Are you financially literate? Find out how clear you are about investing
Though the financial services industry claims that it is spreading investor awareness, a significant percentage of educated Indians remain financially illiterate. An online survey conducted by ET Wealth last month throws up worrying figures. Nearly two out of five respondents (37%) have not heard of direct plans of mutual funds, and one out of five (21%) believes that SIPs make investments in equity funds risk free. Direct plans, launched more than three years ago in January 2013, have lower charges and therefore, offer higher returns to investors. And SIPs help reduce, but not completely remove, the risk of equity investments.
While ignorance about investment opportunities and the risks they entail can hurt, lack of knowledge can also put the individual on the wrong side of the law. Two out of three respondents (64.7%) were not aware that interest from fixed and recurring deposits was fully taxable. Not mentioning this income in returns or ignoring tax on it could fetch a tax notice.
Though the survey had 865 respondents, the sample was bedevilled by the usual biases. An overwhelming 91% were males, and 68% of the respondents were below 40. However, the respondents were evenly spread out when it came to income levels.
At the first level, financial literacy is basic knowledge of money. Since all respondents were graduates and above, we assumed they were literate at the first level. At the secondary level, financial literacy is how an individual applies the information he has for monetary gain. For example, an investor is financially literate if he is able to compare two financial products and choose the one that suits him more. Financial literacy is also the ability to understand new products, such as the NPS and direct plans of mutual funds.
Our survey gauges the financial literacy at the second level. We tested knowledge of four widely known investment products— mutual funds, PPF, NPS and tax-free bonds. We left out bank FD and RDs because most educated Indians know how they work. Insurance was also kept out of the survey because it is not strictly an investment product.
We have also looked at how awareness varies across age groups and income levels. This is important because each age group and income level is a separate subset. The first age group (below 30) has just started working while the last group (above 50) is nearing retirement. Similarly, an investor’s need for financial products depends on his income level. Why should one bother about tax saving instruments if his income is not too high?
Knowledge of MFs
Most people know of them, but few really understand.
Almost everybody knows about mutual funds, and only a small segment (8.7%) of respondents said they were unaware. However, even those who know about mutual funds have grave misconceptions about what these instruments really are. “Some investors think all mutual funds are alike. They do not understand that there are several types of schemes, each catering to a different need,” says Suresh Sadagopan, Founder, Ladder7 Financial Advisories.
There is also a small segment of investors (4.6%) who believe that mutual funds are a scam. These must be people (or their friends and relatives) who invested when the benchmark indices were at their peak and sold when panic gripped the market. Some of these investors might also have lost money in mutual fund schemes due to mis-selling (fund houses were pushing tech schemes in 2000 and infra funds in 2007). The industry needs to make extra efforts to win back the confidence of this disgruntled segment and make them invest again.
Direct plans of mutual funds were launched more than three years ago, but two out of five respondents don’t know about them. As mentioned earlier, these direct plans have lower costs because they are sold directly to the investor without an intermediary. The difference in the charges can be as high as 100-125 basis points in case of equity funds and 25-50 basis points in case of debt funds. Lower charges mean these funds offer higher returns to investors than regular plans.
In the long term, a 100 bps higher return can translate into a big difference. “My colleagues from IITs and IIMs in the finance sector didn’t know about direct plans. When I first told them, they just couldn’t believe it,” says Sharad Singh, Founder and CEO of Invezta, a portal dedicated to direct plans.
Why are 37% of educated investors unaware of instruments that promise them higher returns? “Fund houses have not made a significant effort to educate investors about direct plans and their benefits. I have not seen a single ad for direct plans,” says Singh. The illiteracy about direct plans is more pronounced in case of low income groups.
Corporate investors and HNIs have already shifted to direct plans. Younger investors are also not as aware of these schemes as older investors. This could be because their mutual fund portfolios are smaller and the benefit of shifting to direct plans is marginal. Nearly 21% of the respondents know about direct plans, but prefer to continue with regular plans. Singh believes this is because people do not understand the impact of commissions on total costs. “There is a misconception about mutual fund commission. Many investors think that it is a one-time affair and not an annual charge,” he says.
The benefits of SIPs
The other big misconception relates to systematic investment plans (SIPs). Most respondents (91.8%) have heard of them, but do not understand them. “Some investors think of SIPs as a separate investment product. They don’t understand that it is just a mode of investing in mutual funds,” says Gajendra Kothari, MD & CEO, Etica Wealth Management. Secondly, investors think SIPs are synonymous with investments in equity funds. This is because the industry has always talked of SIPs in equity funds in its communication. “Mutual funds talk about equity SIPs and rarely have ad about SIPs in debt funds,” says Sadagopan.
But these are harmless misconceptions. The big problem is many investors believe that SIPs are a sure shot success formula. More than 21% of the respondents said SIPs make investments in equity funds risk free. This is a fallacy. SIPs only reduce the risk by diversifying across time, but do not completely remove the risk of investing in equities.
PPF, NPS, tax-free bonds
Not many understand benefits of NPS and tax-free bonds.
Many of those who say the NPS is unsuitable may change their views if they were told about its benefits. The scheme has the lowest fund management charges among all market-linked investments. Mutual funds and new online Ulips charge Rs 1,500-2,500 a year for managing a corpus of Rs 1 lakh. NPS funds charge only Rs 10.
The ultra-low costs of the NPS have become a hurdle in spreading awareness about it. “Since pension funds are not making money, they can’t spend on investor awareness activities. Even if the fund management charges are raised to 0.25% per year, NPS will remain the cheapest investment product. It will be a win-win for all,” says Sumit Shukla, CEO of HDFC Pension Funds.
The low commission paid to distributors is another hurdle. A distributor gets only a onetime 0.25% commission for fresh investments, unlike in case of mutual funds which keep paying a trail commission to the distributor till the amount remains invested. There is, therefore, hardly any incentive for a distributor to push the product or suggest it to a client. This is despite the tax benefits heaped on the NPS in successive budgets. The 2015 Budget gave an exclusive Rs 50,000 deduction for NPS while the 2016 Budget has proposed that 40% of the corpus will be tax-free.
Tax-free bonds suffer from the same problem. There is practically no push from the issuers so it is not a surprise that over 22% of the respondents don’t know about tax-free bonds. “While insurers and fund houses spread awareness about their products, NPS and tax-free bonds get left behind because of the lack of push,” says Dinesh Rohira, Founder & CEO, 5nance.com.
How interest compounds
Two out of five respondents did not know.
The impact of compounding is important and investors must have basic knowledge of this concept to assess the returns from various instruments. Yet, two out of five respondents don’t know how compounding works. If a bank offers 8% interest compounded quarterly (or 2% per quarter) on its 10-year deposit, an investment of Rs 1 lakh will grow to Rs 2.2 lakh in 10 years. However, banks often project this as an effective yield of 12%. “Banks and financial institutions presents the maturity amounts in such a way that the investor gets taken in,” says Rohira.
Salesmen, especially life insurance agents, use this illiteracy to push financial products. They tom-tom a very huge maturity amount to make an investment look very attractive. A monthly investment of Rs 5,000 growing to Rs 25 lakh in 20 years may sound lucrative but the returns are only 6.8%.
Investors also get misled by various power of compounding calculators. Mutual fund salesmen usually assume a compounded return of 15% to showcase very large final value. “But the compounding calculators show a straight-line increase and don’t capture the possible downside during the investment period,” says Rohira. If the possibility of volatile returns is not explained upfront, it amounts to miscommunication and could create problem later.
The power of compounding works not just in investments but in other financial products as well. The credit card company may charge only 3% interest per month on the balance he rolls over, but the power of compounding makes it 42.6% annually. Interestingly, the illiteracy is highest among respondents aged 30-40 years. People younger than 30 and older than 40 were more informed.
Awareness of tax rules
Even high income earners harbour misconceptions.
Apart from investment products and calculation of returns, investors should also be aware of tax rules. Surprisingly, only one out of three respondents know that the interest received on fixed deposits and recurring deposits is fully taxable. A lot of investors think that since TDS has been deducted on the interest from their fixed deposits, they need not pay any more tax. “Many people don’t understand that TDS and final tax liability are separate issues,” says Adhil Shetty, CEO, BankBazaar.
Tax-saving fixed deposits is another cause for confusion. Investors think that since these are tax saving deposits, the income is also tax-free. Though the taxpayer is eligible to claim deduction for the amount invested in the tax saving deposit under Section 80C, the interest earned on the deposit is fully taxable.
The infrastructure bonds issued five years ago offered tax deduction under Section 80CCF, but the income from them has to be reported and tax has to paid on it. It’s worrisome to note that this illiteracy exists even among high income earners. More than 60% of the respondents who earn more than Rs 25 lakh a year believe that the interest from bank FDs is not taxable. These investors may get into trouble because the income tax infrastructure is getting into shape in India and banks are reporting the interest paid with PAN details.Even if TDS has been deducted, the taxpayer may have to pay additional tax. TDS is only 10% and if he earns Rs 5-10 lakh a year, he will have to pay 10% more. If income is more than Rs 10 lakh a year, he will have to shell out 30% in tax. To be sure, this is more a literacy issue and not a deliberate attempt to evade tax. Even so, if he has not paid tax on fixed deposit interest, the taxpayer may get a tax notice and may have to pay a penalty for non-payment of tax.
Need for diversification
Too few stocks and too many mutual funds may not be of much use.
Diversification helps reduce risk by spreading the portfolio—across sectors, across a basket of securities or even across asset classes. However, not many respondents understood the meaning or impact of diversification. A majority (54%) believed that diversification will not reduce risk. Even some of those who said that diversification reduces risk have not fully understood the concept.
About 15-25 stocks and around five mutual funds schemes are enough for reasonable diversification of the portfolio. While a majority of the respondents got this right, a good 31% said that five stocks are enough to diversify the portfolio. Five stocks will certainly not diversify.
On the other hand, most respondents (75%) were aware that five mutual funds were enough to give a reasonable level of diversification to the portfolio. Even so, one out of four respondents believes that you need 10-25 schemes to diversify the portfolio. Such a large number of funds will not diversify but add to the investor’s paperwork. Most schemes in a category follow the same benchmark indices and therefore, have nearly the same portfolios. Holding 10-15 schemes that hold the same stocks is a meaningless exercise.
Understanding the concept of inflation is critical in financial planning. “Everyone experiences inflation. They understand it too, but don’t consider its impact while planning for the future,” says Jitendra Solanki, Registered Investment Adviser. They try to attain future goals based on current costs. A 4-year engineering degree costs around Rs 8 lakh now, but in 10 years the cost would have escalated to around Rs 30-35 lakh. Barely 44% of respondents understood the full impact of inflation.