Comparators to analyse financial tools

Many a time people ask, “Suggest a good mutual fund.” This question is akin to asking a doctor, “Give me a good medicine.” How can the doctor suggest anything without knowing the problem?

This article will cover most of the relevant methods to compare investments. The idea is to arm ourselves with the right questions so that we can get the right answers to achieve our financial goals.

The comparators used for analysing financial investment tools are not the same for all tools. So we will in this article see all the comparators and how they are suitable for various tools.

The Returns

There are two components to returns: current income and capital appreciation. Current income is the regular cash flow that we get from investments. These are like interest from a bank deposit, dividend from a company , rent from a house or a commercial building.

Current income may be more important to some people. A regular known income is more needed for a pensioner than a fresher.

Current income is always taxed, either in our hands (in the case of interest) or in the hands of the person paying it (in the case of dividend).

Capital appreciation is the growth in the value of the investment itself. The land that we had bought appreciates in its value. So do shares and mutual funds. As with current income, capital appreciation is preferred by some more than others. A young person would want more of capital appreciation than a person nearing retirement. The issue with any investment that can give capital appreciation is that there can also be capital depreciation — reduction in the value of the investment. So anyone with a firm short-term commitment should look to preserve the capital than look for appreciation.

Risk

Risk is the deviation of actual returns from the expectation. . One of the measures of risk for an investment is its variation in returns from time to time (volatility). If the variation is high, the investment is said to be risky.

That way a bank deposit, though giving lower returns, is less risky as it has minimal variation in returns. However the risk with bank deposits is the interest rate risk. This is so because after I make my investment for five years, the bank may increase the interest rate. So I am not able to reinvest gainfully.

The other risk is with growth being lesser than inflation.

Liquidity

This is the speed at which an investment can be converted to cash. Gold has the highest liquidity as it can quickly be pledged for cash. Shares have the next highest liquidity (two days to cash in from a bank). Mutual funds come next (one to three days for liquid or equity funds).

Real estate is the least liquid among investments.

An important aspect to be considered when investing is the tax treatment. We are moving towards the exempt-exempt-tax regime where investment maturity proceeds will be taxed. The first to come under this regime are pension funds.

Convenience

This is the final measure for comparing investments.

A mutual fund has a very high convenience factor because investments can be as low as Rs 500 a month (even lower in some cases), has professionals to manage it, gives the advantage of diversification, can be redeemed easily (except those with a lock-in period). Real estate is the least convenient as it requires huge investments.

(The author is Chief Executive Officer, BankBazaar.com.)

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