Investment Mistake, Investment Process, Market Cycles

From Beginner’s Luck to Winner’s Curse?

July 13, 2024 No Comments

Consider this: If 1000 monkeys had constructed portfolios of Indian stocks in the calendar year 2021, how many of those 1000 portfolios would have beaten the BSE 500 index after 3 years?

The surprising answer: ALMOST ALL OF THEM (997 of 1000).

No, these aren’t specially gifted/ trained primates; they’re random monkeys with random portfolios. We conducted a simulation with 1000 random portfolios. Each portfolio picked 100 equal weighted stocks at random from the BSE 500 universe in calendar year 2021. To remove starting period bias, we excluded period from May 2020 to December 2020 (marked by a sharp recovery from Covid-19 lows). Additionally, we assumed that stocks were added on a monthly basis throughout calendar year 2021. Then, on March 31, 2024, we compared the performance of these 1000 portfolios with that of the BSE 500 index, assuming a similar monthly purchases of the index. Remarkably, almost all monkey portfolios outperformed BSE 500’s 15% annualised returns from 2021 to March 2024, recording a median return of 22% p.a.

The secret behind this superlative performance lies in the starting point and market’s direction during the study period. Stocks have been on a relentless ascent since Covid-19 lows in May 2020. Many small and midcap BSE 500 stocks with less than 1% weight in the index have surged 3x to 12x. An equally weighted portfolio of random 100 stocks would allocate 1% weight to these stocks. Just a few such stocks are sufficient to improve the portfolio performance materially. Moreover, hardly any stock experienced significant declines to drag down the overall performance. If these portfolios were allowed to include micro caps, IPOs and SME IPO stocks (currently excluded) or reduce the number of stocks from 100 to say 50 or even 30, their performance would have risen further (100% outperformance; over 22% median return).

This outcome – call it beginner’s luck – mirrors the experience of many new investors who entered equity markets post Covid-19. Consistently beating the index is challenging even for seasoned investors. So, after outperforming the index over 3 years, many novice investors may start to believe that they possess a Midas touch for stock picking. However, in reality, the past 3 years’ success is largely attributable to luck. Worryingly, nothing sets up someone for financial and/or emotional ruin more than luck mistaken as skill and/ or an imprudent approach rewarded handsomely. Emboldened by their riches, many investors will raise their bets (trade in options, dabble in stocks of questionable companies etc.) precisely at the wrong time, and fall victim to the winner’s curse.

We also conducted a reality check: we made those 1000 monkeys repeat the same exercise in calendar year 2018. How many of them would have beaten the BSE 500 by June 2020? Only 200 out of 1000, with a median return of -6%. The reason? The markets were in decline from 2018 to June 2020.

Liquidity can propel stock prices to any level in the short term. However, fundamentals and valuations ultimately serve as anchors. Until then, ironically, a thoughtful investing approach may seem foolish, while a foolish investing approach may appear thoughtful. It’s therefore difficult to correctly evaluate performance in a uni-directionally rising market. The true test of investment skill lies in a falling market. Correct evaluation period should encompass a full market cycle, not just one phase as is the case with last three years. A full cycle is when margins and multiples both mean revert. A strong performance across full cycle results from being mindful of risks in a rising market and maintaining the price and quality discipline consistently.

Investment Mistake

An “investment” product to strongly avoid

July 13, 2024 No Comments

Rs 144 trillion. This is the size of India’s favourite financial savings instrument– bank fixed deposits. Rs 30 trillion. This is the next favourite instrument. Can you guess what is it? This is the size of savings plans of life insurance companies. This is twice the size of debt mutual funds in India and is 50% higher than combined sum held as current and savings deposits with banks.

A typical insurance savings product is pitched like this (LIC Bima Jyoti): Invest Rs 10,000 every month for 15 years. Get Rs 30 lacs at the end of 20 years. Get tax benefit under section 80C. Redemption proceeds are tax free as well.

What is not expressly told is that this will give a return of just 6.6% p.a. after GST and income tax benefits (assuming 30% tax bracket). And that there is a lock-in period of 5 years. Failure to pay premium in any of the first five years, not only will lead to loss of tax benefit but also attract surrender charges. Sadly, around 50% of people close their policies before 5 years and their net returns are much lower.

For such a long duration commitment there are better alternatives. A PPF that comes with similar benefits and 15 year term returns 7.1%. In fact, an ELSS (equity mutual funds that are eligible for section 80C benefits), which has just 3 year lock-in can return even higher. In last 20 years it has returned over 12% p.a. after tax. For death benefits a pure term insurance plan is much better. A Rs 1 crore cover can be obtained at an annual premium of around Rs 20,000.

It is extremely fascinating how the confluence of (a) high commissions, (b) tax benefits and (c) human fallacies have created such a colossal but nearly useless product.

Life insurance savings products pay around 30% commissions to agents on first year premium and upto 15% from second year onwards. An agent will prefer selling these over a mutual fund that earns him just 1% for same investment garnered. That’s why your favourite finfluencer has started peddling these products in their “educational” Youtube channels. And that’s why your bank RM or distant relative talks so sweetly to you while suggesting investment options.
Life insurance products were given tax benefit so that more and more people secure financial safety of their dependents. The tax benefits were created envisaging pure term policies that only pay death benefit. However insurance companies have misused this benefit for creating FD like products.
Lastly, investors drop their guards as soon as they hear “guaranteed returns” and “tax benefits”. Many are not able to calculate the internal rate of return (IRR) embedded in these products. Finally, they rush to buy these products in March, just before the end of financial year without proper evaluation.

Best exit action for those stuck with such products, is to hold them till the lock in period of 5 years and then surrender the policies. This will help retain the tax benefit on redemption and minimise surrender charges.

Investment Mistake, Investment Process

Preferred Way to Reduce Risk in a Rising Market

July 13, 2024 No Comments

“Risk means more things can happen than will happen”

-Elroy Dimson

In a rising market, most investment/ trading styles do well despite overpaying. For, money gushing into any asset class can raise its price irrespective of underlying value. Prudence and safety are needless, even penalised during such times. But like most good things, such good runs – even if they extend over a long time – eventually reverse. Waking up to build controls after such reversal is too late.

Portfolio safety is like a car’s seat belt. Both are minor irritants in good times, but life-saving during accidents. Just as it is prudent to always wear seat belts tolerating minor discomfort, it is important to control risk in portfolios even in good times tolerating lower relative returns.

Our preferred way to reduce risk in the portfolio is to buy a diversified set of good companies cheaply and hold them till they remain good and don’t get super expensive. Yes, there is an inherent conflict in this goal. Markets have become more efficient and everyone is trying to do the same. So good companies donot come cheap. Mostly. But there are two pockets where mispricings are common. First is temporary hardships either in the world, country, sector or company during which even good companies get traded at throw away prices. And second is smaller companies which are not so well tracked and/ or are less liquid and can remain mispriced.

Doing the above is easy in theory but difficult in practice. We need to exercise discipline and have safety margin in all the three components – (a) diversified uncorrelated positions, (b) good companies, and (c) reasonable valuations.

And while doing the above, there are bouts of luck and mistakes. Many times, probable outcomes don’t happen and/ or improbable outcomes happen. Often we get good outcomes beyond our expectations due to plain good luck. These times call for humility and trimming positions that get super expensive. Conversely despite doing the right thing our positions can fall. If there is no material deterioration in underlying fundamentals, these are times not for despondency or self-pity, but raising our bets. Lastly, we make mistakes; they are normal in a pursuit of higher than risk-free returns. When we make mistakes, mention of their account precedes that of achievements so that we don’t lose the lessons.

Investment Mistake, Investment Process

Focus on Intrinsic Value

July 13, 2024 No Comments

“What do you see, son”? Asked Guru Dronacharya. “Only the bird’s eye, Sir”, replied Arjun.

-the Mahabharat

We all have grown up listening to this Mahabharat story on importance of focus. Whether its archery or investing, great achievements demand undivided focus. The bird’s eye equivalent in long term investing that demands undivided focus is company’s intrinsic value (or economic worth, in simpler terms). For, only that can help us decide if a company is undervalued or overvalued versus its stock price. Everything else, is noise.

To recall, a company’s intrinsic value is the present value of its future free cash flows. Two broad components of intrinsic value calculation are (1) future free cash flows (i.e. cash earnings less investments) and (2) future interest rates to discount those cashflows to their present values (aka discount rates).

Assessing intrinsic value, thus, requires looking into the future – for both cash flows and discount rates. Unlike Arjun’s bird in the Mahabharat that is still and clearly visible, intrinsic value is therefore a moving and hazy bird.

Future cashflows: Either due to their nature or our current ignorance, we cannot imagine future cash flows of most of the companies. It’s futile to even attempt their intrinsic value calculations. For, in archery parlance, we cannot even see the bird. Nonetheless, there is a sub set of companies where we can. Mostly these companies provide essential, under-penetrated or non-substitutable products/ services competitively and are run by able and honest management. They are expected to see reasonable revenue growth and high returns on capital. Here is where we limit ourselves looking.

Future interest rates: For intrinsic value purposes we are concerned, not with interest rates of next quarter or year, but with long term future interest rates. Just as assuming very low long term future interest rates is mistaken (last 10 years), so is assuming very high long term interest rates (temptation today). We need to assume moderate interest rates over long term in our intrinsic value assessment. Given that 30-yr Indian government securities are yielding around 7% today (2024), 4% is too low, and 15% too high for discount rate. Anywhere between 10%-12% sounds okay, today.

We need to place all incoming information in above backdrop. Discipline to limit ourselves to sound companies and focus on their intrinsic values that correctly embeds future cashflows and long term future interest rates will allow us to ignore noise and take right investment actions.

Investment Mistake, Investment Psychology, Market Cycles

Buy High. Sell Low. Repeat. Go Broke

July 12, 2024 No Comments

Nothing is as financially ruinous as consistently buying high and selling low. Yet we see it happening all the time. Ignorance, emotions, and miss-selling interact with each other to powerfully induce this folly.

Without a sense of a company’s worth, it is impossible to judge whether its share price is high or low. Assessing that worth requires understanding of underlying business and many investors donot have time, interest or ability to do it. Price trend is generally used as a substitute for this ignorance about intrinsic value. Companies seeing price rising are considered as good and vice versa. When more people believe in this momentum, it becomes a self-fulfilling prophecy. Ignorance encourages buying assets that are rising.

Nothing intoxicates human mind as rising prices. Rising prices trigger emotions of envy, FOMO (fear of missing out) and greed. Those sitting on side-lines get interested. And those making money feel invincible and take more risks even on leverage.

Times of rising markets is business-season for many “experts” – distributors, advisers, brokers, merchant bankers etc. Sadly, financial incentives of almost all “experts” are linked to selling financial products – stocks, mutual funds, IPOs, insurance policies – and not good outcomes for investors. This leads to miss-selling. Mutual funds, life insurers and capital raising companies paid over INR 37,000cr (rough conservative estimate) worth of commissions in 2021 to these “experts”. This was paid without any linkage to the buyers’ returns from the financial products sold.

When willingness to buy during rising prices is met by advice that pays the advisor for selling expensive products, it creates a powerful force to buy high.

The same story reverses when prices fall. In absence of sense of intrinsic value most investors fail to assess whether paper losses are temporary or permanent. Momentum and emotions trigger a rush for the door. And those “experts” who peddled the products during rising prices either disappear or are not heard.

Here’s a crude antidote to this: When past returns of an asset class are high, ignore all temptations and “expert advice” of even higher returns. Conversely, when past returns of an asset class are low or even negative, ignore anything that stops you from investing. Lastly, when taking help from “experts”, see that they are remunerated for results, not selling products. When you get a call from a life insurance agent, just hang up!

Investment Mistake, Investment Psychology

Difficulties of Being in a Bull Market

July 12, 2024 No Comments

“I don’t predict future. I understand human nature”

-Lord Krishna to Arjun in The Mahabharata

Thanks to our genetic wiring; envy, greed and fear (of losing out) are three primary human emotions every bull market stimulates. We acknowledge usefulness of these human emotions. Emotions including envy, greed and fear have been instrumental in human survival and superiority over other species since life’s origin. Being envious forced us to compete and improve. Being greedy made us accumulate and overcome scarcity. And, being fearful triggered the fight/ flight responses necessary for survival. These emotions therefore, with generations, are so etched into human consciousness that they operate automatically and indiscretionally, including, in a bull market. Unfortunately, going by financial markets’ history, these emotions when drive actions, lead to bubbles and crashes.

Focus, however, has to be on business value all the time; especially during bullish times. During bullish phases, envy, fear of losing out and greed sets in. Prices get higher and opportunities reduce. By not chasing momentum, a careful investor is bound to see temporary and reversible periods of underperformance. Being patient is never easy, especially if your neighbour is getting richer in a bull market. But this is exactly what one needs to try to do! This approach is better than chasing hot stocks and burning fingers in next correction. A thoughtful investment approach focuses at least as much on risk as on return. Whenever it has been easy to make money in equity markets, it has been even easier to lose it. Earning 16% for 10 years each will leave one with more money than earning 20% in 9 years each and losing 15% in the 10^th.

Investment Mistake, Quarterly Update

Letter to Investors – Mar’23 – Extracts

April 7, 2023 No Comments

EXECUTIVE SUMMARY

- Adjusted trailing twelve months’ earnings of underlying portfolio companies grew by 11%.
- FY23 NAV fell by 4.3% with 70% funds invested. NSE Nifty 50 and Nifty 500 grew by 0.6% and -1.2% respectively.
- We made one mistake that cost us 1% of AUM. Details inside.
- We added to tracking position in one company and made it a major position. Detailed thesis was shared with investors.
- Regime changing from TINA to TANIA is leading to flight to safety.
- Stance: Neutral

Dear Fellow Investors,

“Risk means more things can happen than will happen”

-Elroy Dimson

In a rising market, most investment/ trading styles do well despite overpaying. For, money gushing into any asset class can raise its price irrespective of underlying value. Prudence and safety are needless, even penalised during such times. But like most good things, such good runs – even if they extend over a long time – eventually reverse. Waking up to build controls after such reversal is too late.

The decade old world wide party-tide of low interest rates that raised all asset prices is ebbing. Not only has it brought down risky pockets like crypto and expensive tech/ growth/ IPO stocks, but even those exposed to otherwise deemed risk-free assets like US government securities (two regional US banks that held US government securities have been closed). As they say, risk is what is left after you have thought through everything.

Portfolio safety is like a car’s seat belt. Both are minor irritants in good times, but life-saving during accidents. Just as it is prudent to always wear seat belts tolerating minor discomfort, it is important to control risk in portfolios even in good times tolerating lower relative returns.

Our preferred way to reduce risk in the portfolio is to buy a diversified set of good companies cheaply and hold them till they remain good and don’t get super expensive. Yes, there is an inherent conflict in this goal. Markets have become more efficient and everyone is trying to do the same. So good companies donot come cheap. Mostly. But there are two pockets where mispricings are common. First is temporary hardships either in the world, country, sector or company during which even good companies get traded at throw away prices. And second is smaller companies which are not so well tracked and/ or are less liquid and can remain mispriced.

Doing the above is easy in theory but difficult in practice. We need to exercise discipline and have safety margin in all the three components – (a) diversified uncorrelated positions, (b) good companies, and (c) reasonable valuations.

And while doing the above, there are bouts of luck and mistakes. Many times, probable outcomes don’t happen and/ or improbable outcomes happen. Often we get good outcomes beyond our expectations due to plain good luck. These times call for humility and trimming positions that get super expensive. Conversely despite doing the right thing our positions can fall. If there is no material deterioration in underlying fundamentals, these are times not for despondency or self-pity, but raising our bets. Lastly, we make mistakes; they are normal in a pursuit of higher than risk-free returns. When we make mistakes, mention of their cumulative account precedes that of achievements so that we don’t lose the lessons.

When evaluating our performance, please see whether or not we have bought good companies at good prices. Also see whether we have behaved appropriately while going through good or bad luck. Lastly, see if our mistakes were new (pardonable) or repeat of old (unpardonable). Our letters try to help you do that. Looking only at trailing short term return may not give full picture.

A. PERFORMANCE

A1. Statutory PMS Performance Disclosure

Portfolio	FY23	FY22	FY 21	FY 20*	Since Inception*	Outper-formance	Cash Bal.
CED Long Term Focused Value (PMS)	-4.3%	14.9%	48.5%	-9.5%	11.2%		30.0%
NSE Nifty 500 TRI (includes dividends)	-1.2%	22.3%	77.6%	-23.6%	14.3%	-3.1%	NIL
NSE Nifty 50 TRI (includes dividends)	0.6%	20.3%	72.5%	-23.5%	13.5%	-2.3%	NIL
*From Jul 24, 2019; Since inception performance is annualised; Note: As required by SEBI, the returns are calculated on time weighted average (NAV) basis. The returns are NET OF ALL EXPENSES AND FEES. The returns pertain to ENTIRE portfolio of our one and only strategy. Individual investor returns may vary from above owing to different investment dates. Annual returns are audited but not verified by SEBI.

We were down marginally this year. Being in the same boat as yours, we did not charge any fees in FY23.

Many of our positions are sector leaders going through temporary hardships. They are trading at low/ reasonable valuations in light of their fundamentals. We have used this opportunity to add to these positions. Cash balance has fallen from high of 38% early this year to 30% currently including new inflows.

A2. Underlying business performance

Past Twelve Months	Earnings per unit (EPU)²	FY 2023 EPU (expected)

Dec 2022	5.5¹	5.2-6.2³
Sep 2022 (Previous Quarter)	5.4	5.2-6.3
Dec 2021 (Previous Year)	5.9
Annual Change	11%⁴
CAGR since inception (Jun 2019)	6%
¹Last four quarters ending Jun 2022. Results of Jun quarter are declared by Nov only. ² EPU = Total normalised earnings accruing to the aggregate portfolio divided by units outstanding. ³Please note: the forward earnings per unit (EPU) are conservative estimates of our expectation of future earnings of underlying companies. In past we have been wrong – often by wide margin – in our estimates and there is a risk that we are wrong about the forward EPU reported to you above. ⁴Adjusted earnings.

Trailing Earnings: Adjusting for temporary losses in the base and current period, trailing twelve months Earnings Per Unit (EPU) of underlying companies grew by 11% (including effects of cash equivalents that earn ~5%).

1-Yr Forward Earnings: We are retaining the last letter’s estimate of FY 23 earnings per unit to Rs 5.2-6.2.

A3. Underlying portfolio parameters

Mar 2023	Trailing P/E	Forward P/E	Portfolio RoE	Portfolio Turnover¹
CED LTFV (PMS)	26.8x	25.5x	16.8%⁴	5.5%
NSE 50	21.1x²	–	15.1%³	–
NSE 500	20.4x²	–	13.7%³	–
¹ ‘sale of equity shares’ divided by ‘average portfolio value’ during the year to date period. ² Source: NSE. ³Source: Ace Equity. ⁴Excluding cash equivalents.

B. DETAILS ON PERFORMANCE

B1. MISTAKES AND LEARNINGS

Mistake: Music Broadcast Bonus Preference Shares (Special Situation)

We have a paper loss of 1% of AUM in a special situation that we participated in last quarter. This was about bonus (i.e. free) preference shares to the equity shareholders of Music Broadcast ltd.

Please note this is not a core equity position; it was a way – unsuccessful till now -to put our spare cash to temporary use. Such cases are called as “special situations” in investing parlance.

Music Broadcast runs the radio channel Radiocity. The newspaper group Jagran Prakashan is the parent of the company with a 74% stake. Radiocity announced bonus preference shares to its minority equity shareholders in the ratio of 1 bonus preference shares of FV of Rs 100 each for 10 shares of Music Broadcast (then CMP Rs 25). The bonus preference share were to be allotted for free. In simpler words any non-promoter shareholder holding shares worth Rs 250 was entitled to bonus shares worth 100 free (i.e. 40% of cost). Additionally, these preference shares will list on stock exchanges soon (we can sell in the market) and will be ultimately redeemed @ Rs 120 in 3 years.

Think of bonus preference shares as delayed dividend. Instead of paying immediately, the company will distribute the sum after 3 years (at 20% premium). Normally a dividend equal to 10% of market cap leads to fall of 10% in share price once the stock goes ex-dividend. Given that these bonus shares are being given to minority shareholders that hold only 26% stake, post record date the stock price should fall by 40% of 26% i.e. 10.4%.

We made a 3.5% allocation to Music Broadcast at price of Rs 26.6 per share to play this special situation. Even if price were to fall 30% once stock goes ex-date we would have made 12% in a couple of months.

Or so we thought! In reality, post the ex-date, while we got the free bonus shares (worth 38% of our cost), the equity share actually is down 59% as of this writing. Even if we go back to the price of Rs 17.7 on Oct 22, 2020 when the bonus was first announced, the stock has fallen 39% from then price.

The only explanations can be that (a) bonus was already in price way before we thought and/ or (b) owing to low liquidity and rush to sell the main equity shares after ex-date, the stock has corrected steeply.

Now that reality has not turned as we had imagined, should we sell the equity shares immediately? Four reasons require us to pause. First, free cash will form over 75% of market capitalisation (including preference shares) of the company. Second, this is pre-election year which is normally good for Radiocity’s advertising revenues. Third, management has been pro-shareholders (Jagran Prakashan, the parent has done 8 buybacks in last 9 years).

And the forth reason is harvesting tax losses. If we hold this position for 9-12 months, (a) we claim tax loss on main equity shares (bonus stripping) and (b) have that as short term loss (15%) versus long term (10%). This means if we sell between 9-12 months, we can use 15% of the ‘notional’ loss to set off future capital gains. Notional because, it is not actual loss, we have received bonus preference shares for free in exchange. Nonethless, we will sell it before 9 months if we are getting a good price.

The bonus preference shares on the other hand will list shortly, and we will decide to sell, buy or hold based on the price at which they start trading.

Learnings – We should not leave such positions open. A perfect special situation is one when returns are locked irrespective of how market moves. So if similar situation was to take place in a stock that was also traded in futures & options (F&O) we could have sold the stock in futures and locked the gain. Second, we need to undertake special situations in companies that we would be okay to hold if things donot immediately turn the way we expect.

**

Previous mistakes (2014-2018): From our two past mistakes- “Cera Sanitaryware (2014)” and “2015-16” – we learnt that unless fundamentals are extremely compelling, it is better to be gradual in selling and buying respectively. From our past mistake on “Treehouse Education” we have learnt that bad management deserves a low price, it’s seldom a bargain. In Dish TV we underestimated the competitive disruption but thankfully sold at breakeven. Tata Motors DVR taught us that cyclical investing requires a different mindset to moat investing and one needs to be quick to act when external environment turns adverse. In Talwalkars, we learnt that assessing promoter quality is a difficult job and we should err on the side of caution irrespective of how cheap quantitative valuations look. From DB Corp we learned that industries in structural decline will fail to get high multiples even if the industry is consolidated, competition limited and free cash flows healthy.

B2. MAJOR PORTFOLIO CHANGES

We increased our tracking position to a ~4% position in one of the companies. In addition we added to our position in four other companies as the prices became reasonable.

B4. FLOWS AND SENTIMENTS

SVB and Flight to Safety

US based Silicon Valley Bank (SVB), 16^th largest US bank by assets, closed down last quarter due to run on the bank. This was precipitated by rise in US interest rates from nil to over 4% within a year.

Concentration in deposit and loan book was the main mistake that SVB made. Here is the summary of what happened:

SVB had invested most of its deposits in long dated US government securities (bonds). Sharp rise in US interest rates led to mark to market losses on its bond portfolio (bond prices fall as interest rates rise). SVB had raised deposits from start-ups and they began pulling out deposits as venture capital dried up (again a fallout of rising interest rates). This forced SVB to sell bond portfolio at losses which nearly wiped out its equity capital. And then rumours led to run on the bank. US government guaranteed the deposit holders and closed the bank.

Globally, central banks including the US Fed are caught in the dilemma of maintaining financial stability and controlling inflation. We believe they will continue to safeguard bank depositors and keep interest rates high until inflation is firmly under control. Preference for safety over returns may, therefore, continue leading to moderation in global equity flows.

***

Back in India, retail flows including mutual fund SIPs continue to counter the selling by foreign investors. That partly helped Indian equity market remain insulated from global turmoil so far. As last 12-18 month returns turn negative, retail flow may moderate. All this should mean that we will continue to get opportunities to deploy our spare cash in coming days ahead. Average valuation of last 10 year’s TINA (there is no alternative) regime may not be correct benchmark for upcoming TANIA (three are new investment alternatives) regime. We will be mindful of this while deploying.

C. OTHER THOUGHTS

An “investment” product to strongly avoid

Rs 144 trillion. This is the size of India’s favourite financial savings instrument– bank fixed deposits. Rs 30 trillion. This is the next favourite instrument. Can you guess what is it? This is the size of savings plans of life insurance companies. This is twice the size of debt mutual funds in India and is 50% higher than combined sum held as current and savings deposits with banks.

A typical insurance savings product is pitched like this (LIC Bima Jyoti): Invest Rs 10,000 every month for 15 years. Get Rs 30 lacs at the end of 20 years. Get tax benefit under section 80C. Redemption proceeds are tax free as well.

What is not expressly told is that this will give a return of just 6.6% p.a. after GST and income tax benefits (assuming 30% tax bracket). And that there is a lock-in period of 5 years. Failure to pay premium in any of the first five years, not only will lead to loss of tax benefit but also attract surrender charges. Sadly, around 50% of people close their policies before 5 years and their net returns are much lower.

For such a long duration commitment there are better alternatives. A PPF that comes with similar benefits and 15 year term returns 7.1%. In fact, an ELSS (equity mutual funds that are eligible for section 80C benefits), which has just 3 year lock-in can return even higher. In last 20 years it has returned over 12% p.a. after tax. For death benefits a pure term insurance plan is much better. A Rs 1 crore cover can be obtained at an annual premium of around Rs 20,000.

It is extremely fascinating how the confluence of (a) high commissions, (b) tax benefits and (c) human fallacies have created such a colossal but nearly useless product.

Life insurance savings products pay around 30% commissions to agents on first year premium and upto 15% from second year onwards. An agent will prefer selling these over a mutual fund that earns him just 1% for same investment garnered. That’s why your favourite finfluencer has started peddling these products in their “educational” Youtube channels. And that’s why your bank RM or distant relative talks so sweetly to you while suggesting investment options.
Life insurance products were given tax benefit so that more and more people secure financial safety of their dependents. The tax benefits were created envisaging pure term policies that only pay death benefit. However insurance companies have misused this benefit for creating FD like products.
Lastly, investors drop their guards as soon as they hear “guaranteed returns” and “tax benefits”. Many are not able to calculate the internal rate of return (IRR) embedded in these products. Finally, they rush to buy these products in March, just before the end of financial year without proper evaluation.

Best exit action for those stuck with such products, is to hold them till the lock in period of 5 years and then surrender the policies. This will help retain the tax benefit on redemption and minimise surrender charges.

***

As always, gratitude for your trust and patience. Kindly do share your thoughts, if any. Your feedback helps us improve our services to you!

Kind regards,

Team Compound Everyday Capital

Sumit Sarda, Surbhi Kabra Sarda, Punit Patni, Arpit Parmar, Sanjana Sukhtankar, Anand Parashar

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Disclaimer: Compound Everyday Capital Management LLP is SEBI registered Portfolio Manager with registration number INP 000006633. Past performance is not necessarily indicative of future results. All information provided herein is for informational purposes only and should not be deemed as a recommendation to buy or sell securities. This transmission is confidential and may not be redistributed without the express written consent of Compound Everyday Capital Management LLP and does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Reference to an index does not imply that the firm will achieve returns, volatility, or other results similar to the index.