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Monday, June 25, 2018

Opportunity cost of safe investing

Your financial goals should determine your investment

Written by Kartik Jhaveri | Published: May 28, 2012 1:52:08 am

You tell your advisor that you pay 30 per cent tax on your income and that you do not want to lose any money. Thus your advisor tells you that the best thing to do is to put money in a FMP (Fixed Maturity Plan) or similar type of product. There are 2 questions that emerge here,why FMP or the likes? and what about opportunity loss?

Why does the advisor recommend FMP and not say a RD or FD? Firstly,FMP or FTP (Fixed tenure plan) are like a short term fixed deposit plan floated by mutual funds. They can be in the range of 30 – 60 – 90 days or even one year or more. This is to suit the purpose of different investors having varied time frame of investments. The rate of return is not guaranteed like the FD but is estimated. Such estimate is fairly correct and deviation being within a very small range. Thus,if you are indicated to earn say 8 per cent you may get final return in the range of 7.9 per cent to 8.1 per cent or thereabouts. The primary reason FMP may score over a deposit is that of tax treatment.

FMP is a much better investment idea given its tax efficiency provided you are in the highest tax bracket. Note that for many people,especially senior citizens,FD may turn out to be a better idea given their tax situation. If the total income for a person falls below the taxable slab or that income is tax managed i.e. based on the accountant’s advice,if a higher income has ample deductions such that tax is mitigated or is marginal,then FD may be an equally good option. Tax slabs are expanding each year as we have been seeing so far thus the income that will be outside the purview of taxation will be larger each year. That means that one can invest in FD and other similar fixed interest instruments to get a pre determined rate of return.

Now we come to the larger area of concern – that of opportunity loss.

So what is opportunity loss? Actually it’s only a paper figure and may not apply to someone who has ample money and has no need to generate additional wealth. It means nothing to someone who only has to simply maintain his money without any financial objective. Such people are fortunate and are few. For the rest of us who have to create wealth,understanding this concept of opportunity loss can imply a world of difference. Lets explore.

Speaking of the example above – if I were the advisor my line of thought would be quite different. Sure people like safety but it is important to understand that nothing is free. Safety also comes at a cost,infact a staggering cost.

Here’s how; a safe investment gives you say,9 per cent. Inflation is at say,10 per cent. Hence,your real rate of return is -1 per cent (difference of rate of returns of money growth minus the rate of erosion of money i.e. inflation rate). Now if you invested into something that is likely to give you a return of say 15 per cent then the real rate of return is 5 per cent (15 per cent minus 10 per cent).

The opportunity cost is the difference of the two real rates of return above i.e. -1 per cent –5 per cent = -6 per cent. Hence by going safe you are making an opportunity loss of 6 per cent each year. In other words you are losing at the rate of -1 per cent by making a safe investment per se and by doing so you are also naturally depriving yourself of making a profitable investment. Thus the loss compounds as you are also losing the opportunity provided by an alternative (perhaps better) investment.

If you invest Rs 1 lakh today in a safe instrument then in 5 years time you make an opportunity loss of R 34,000,and in 10 years’ the loss is R s79,000. The calculation is simple. At 6 per cent compounding in 5 years’ time Rs 1 lakh will give Rs 1.34 lakh and in 10 years Rs 1 lakh will give Rs 1.79 lakh. This growth in money is what you lose by playing safe. If you are not a senior citizen or an extremely wealthy person then following factors determine whether you should do a safe investment or not?

Your age,prevailing and expected inflation,prevailing interest rate scenario,your tax position and finally your financial goals. It is infact a combination of all of these factors put together.

Finally always think before you act. Did you know that if you had R 10 lakh to invest and you invest that safely,the opportunity loss over 10 years might be a staggering R 7.9 lakh.

—Author is Director,Transcend Consulting,

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