IDFC 80CCF Tax Saving Infrastructure Bonds

IDFC has launched their own 80CCF infrastructure bonds, and these come with a slightly higher interest rate than the other bonds that have been released so far.

They carry a 9% annual interest rate, and IDFC has simplified the issue a little bit by having the option with only one maturity – that of ten years.

Like, the other 80CCF bonds, these will have the the annual interest payment or the cumulative option, and a buyback option after 5 years.

The issue opens on November 21, 2011 and closes on December 16, 2011. In the past they have appeared on online platforms like ICICI Direct and Edelweiss, so that’s one way to buy them, or as Austere suggested you can print the forms online and submit it in one of the collection centers.

And of course, there’s always the option of taking the help of financial advisers like Shiv to apply for them.

Here are some other details about the bonds.

Series

1

2

Interest Rate

9%

Cumulative but effectively 9%

Maturity Period

10 years

10 years

Buyback Option

5 years

5 years

Buyback Amount

5,000

7,695

Maturity Amount

5,000

11,840

 

After the lock in period of 5 years, the bond will list on the NSE and BSE.

For whatever it’s worth the issue is rated highly by ICRA and Fitch – both of them rated the issue AAA. To me, it doesn’t make a lot of sense to apply anything more than Rs. 20,000 and that too only on one of these 80CCF bonds, so if you have applied for something already then you are better off investing your money in any other bank fixed deposit which doesn’t have any lock in period and will have a slightly higher interest rate also.

A new question that I see appear a few times with respect to these bonds is if you need to buy it every year to get the tax benefit. I think the source of that question is the confusion between the tax benefit.

Please be cognizant of the fact that the interest is not tax free. The interest will be taxable every year, but the way you get the tax benefit is that the value of bonds that you buy gets reduced from your taxable salary, and that means you have to pay less tax.

The other question that I saw today was would you have to pay tax if you exercised the buyback and the answer to that is that buyback doesn’t affect how the bond is taxed.

If you took the annual interest option then the interest will be taxed every year, and if you took the cumulative option then you will be taxed capital gains. The face value of the bond will not be taxed.

I can’t quite think of anything else to cover about this issue – so if you have any comments let’s hear them and a special thanks to Shiv who informs me about these bonds quite in advance.

Book Review: Steve Jobs by Walter Isaacson

I’ve recently finished reading the much talked about biography of Steve Jobs and absolutely loved it.

It is one of the most honest biographies I’ve ever read and the only biography I’ll place higher on the frankness scale is The Story of My Experiments with Truth.

Much of the book talks about the temperamental nature of Jobs and how harsh he was with people around him and often presents the counter view to what he thought by interviews with the other person.

The best thing about the book is the detailed view it gives on almost all situations that it deals with and because Walter Isaacson interviewed so many people it presents different angles to the same incident and makes it a lot different from what an autobiography might have looked like.

It also brings out the sharp contradictions in Jobs’s personality with many events big and small. One example is Jobs being given up for adoption by his parents, his biological father later on abandoning his mother and him doing the same thing with his daughter but never making amends with his biological father or making special allowances and trying to improve relations with his daughter.

His temper and volatile nature is also written about quite often with several incidents in the book when he yells at people who work with him and even the people who don’t like the elderly woman who worked at Whole Foods and didn’t make a smoothie upto his standards.

There are a few stories about how he trashed people’s ideas and then a week later came back to them and told them the same idea as if it were his own and there was nothing you could do about it.

There were many instances of the famous reality distortion field, which was a term coined by early Apple employees to convey that he could make you feel like you could do something which you yourself didn’t think possible. This extended to others as well as recounted by Wendell Weeks who was the CEO of Corning Glass, the company that supplied Apple with the Gorilla Glass that Apple used in the iPhone.

Apparently, Corning had developed this strong glass in the sixties that they called Gorilla Glass which was very strong but they never found a market for it and stopped making it. Jobs told Weeks that Apple would buy as much glass as Corning could make within six months and Weeks told him they had no capacity and none of their plants make the glass now.

Jobs turned on his reality distortion field and convinced him they could do it and eventually they ended up doing it within six months. There are several other amazing examples of the reality distortion field as well.

Among his other quirks were the fact that he felt that the rules that applied to regular people didn’t apply to him and that showed in the way he drove a Mercedes that didn’t have a number plate or parked in the spot reserved for handicapped people.

That is also a great example of the contradictions in his nature – on one hand he eschewed the idea of having a special parking place for the CEO and on the other hand he didn’t feel anything wrong about parking in the handicapped parking spot in his office.

His relationship with money was another such thing and probably the best example of that is when he worked for a $1 annual salary for two years upon his return to Apple, and initially refused an options grant by his board. Eventually, he asked them for a lot more than they had originally offered and stunned everyone. He later recounted that it was not about the money but about being recognized by his peers.

The books also talks about the amazing things he did and recounts how he changed the computer industry, the music industry, and the phone industry. It is not lopsided in any way and does talk about the amazing attention to detail he paid like noticing that an advertisement missed two frames, and it also talks about how even competitors like Bill Gates showed their admiration for him from time to time.

I didn’t touch upon those things so much in my review because they are already quite talked about and I wanted to recount the things that are not so well known.

Despite all the shortcomings in his nature I felt that what Jobs did, only Jobs could have done. It’s an amazing story of a remarkable man and I would heartily recommend this book to anyone.

How to calculate effective yields on different type of tax saving bonds?

I did a series of posts last year about how yield was being calculated on 80CCF tax saving debt instruments, and I see that there is a need to distinguish yield calculation on those type of instruments with the yields on instruments where interest itself is tax free like the PFC tax free bonds.

But first, we need to look at the nature of the tax benefits in the two instruments.

Tax benefit under the 80CCF bonds: What this does is reduce your taxable income by the amount of bonds you buy, and thereby reduce your tax liability.

So, if you have a taxable salary of Rs. 10.2 lakhs, and you buy Rs. 20,000 worth of these bonds then your new taxable salary will just be Rs. 10 lakhs and you won’t have to pay tax on the Rs. 20,000 that you invested in these instruments.

Since you are in the 30.9% tax bracket – you save  30.9% of Rs. 20,000 or Rs. 6,180 in tax.  Now, keep in mind that this is the only tax benefit you get and  you get this only once.

Once you start earning interest on 80CCF bonds – you are liable to pay tax on them like you are liable to pay tax on the interest you earn from a fixed deposit.

Due to this reason – people felt it was a bit misleading for bond issuers to show what the effective yield was for these bonds by taking the tax benefit into account, but ignoring the tax that you would have had to pay on interest income.

I wrote about this in the limitations on the way yields are calculated for tax saving bonds, and together with the other two posts on calculation of yields on tax saving bonds, and the L&T Finance yield example – these three posts cover all important aspects on the mechanics of yield calculation on such instruments.

Tax benefit under the tax free bonds: The other type of bonds are the tax free bonds whose interest is not taxable. These are like the RBI relief bonds that were issued a few years ago or the PFC bonds that are open for subscription now.

In these type of bonds – you don’t get any tax benefit by way of reduction of your taxable salary, but since the interest itself is tax free – that improves the effective yield, and the higher the bracket you are in – the better it is.

The way to calculate the effective yield on these type of instruments is to use the following formula.

Effective Yield  = {Interest Rate / (1 – Tax Rate)}

Now that you know how both the yields are calculated – it is fairly simple to compare the two. Just take the after tax yields of both the instruments and see which one is higher.

I will have a future post with a Google Spreadsheet to go along with it that shows some live examples, and that should make this mechanism even easier to understand.

Zero credit card interest

One of the things I haven’t touched upon in a while here is thrift and credit card debt.

As the year comes to a close I thought I will do a post on credit card debt and interest on credit cards because I think I’m fairly close to a year in which I pay zero credit card interest.

Last year I paid a nominal amount because I forgot one payment, and the year before last I paid a small amount for the same reason as well.

Paying no interest on credit cards is a really important thing for me and I even listed down getting out of credit card debt as one of the important things to do before you start investing.

To most people, this is because credit card debt brings very high interest with it and that is money down the drain, and while that is a big reason, it’s not the biggest reason by a stretch.

The big reason for me is all the wasteful spending that you are likely doing if you run up credit card bills. When I look at my own bills they are mainly travel, groceries and eating out, and there are several ways that I can and I have reduced them in the past.

This point becomes especially important for people who are fresh out of college and have started earning recently without much financial responsibility to worry about.

Once you get into the habit of spending a “little bit” more than you can pay off with your salary – that little bit only grows every month till it reaches a point where your salary gets over on the first of every month.

This is a ridiculous situation to be in – not only financially, but also in terms of living a meaningful life. If your number one worry is sustaining your lifestyle then that doesn’t allow you to think about growing your net worth or even branching out into things that you truly enjoy doing.  It just takes a lot of your mind space.

Getting out of this is simple – really simple – spend less than you earn, and if you think it is much more complicated than that then you simply aren’t doing it right.

This brief and excellent post by The Weakonomist both explains why this is simple, and also why it doesn’t need to be discussed a lot – just something to be internalized and live by.

Mutual Fund Advisory, 3D Printed Car and Russian Tycoons

First up, Hemant has started a relatively low cost mutual fund advisory service where he will examine your mutual fund portfolio and also give you suggestions on new funds. Quite a few people write to me with a list of their mutual funds and ask what I think of them, and while I don’t have the bandwidth or the expertise to evaluate your funds, this service might be of interest to you.

Next, is this amazing video about a 3D printed car – they printed out the frame of the car and it looks pretty impressive. I’m truly in awe with what 3D printing can do, and this is surely going to be a big wave in the future.

Another interesting video I saw this week was of the improved Sony robot – Asimo – pretty slick what this cute fellow can do.

On to something totally different now – WSJ had this fascinating story about these two Russian tycoons embroiled in a court case.

Equally fascinating was this story on the largest venture capital firm in the world  – I had never heard of this firm, and it was quite good education for me.

Europe is of course the big news these days and this story titled Italy’s turn to spook the world does a good job as a primer to what the Italian debt problem is all about, and why it is such a big deal.

Closer home – this fascinating article from Pakistan’s perspective on trade with India.

At home, BS writes about the government’s problem with revenues this year in this article titled about the other fiscal half.

India’s Chief Economic Adviser is interviewed about 5 books he likes.

Finally, some light humor: ultimate rejection rejection letter.

Enjoy your weekend!

What is Auto Sweep in your Bank Account?

A lot of banks offer a feature where they automatically move money from your savings account to a fixed deposit if your balance goes over a certain threshold. This is known as the auto sweep facility.

Banks have different names for the auto sweep facility, and this site has a list of banks that offer the auto sweep facility along with their names.

Manish has already written a very comprehensive post on auto sweeps, and with over 200 comments it does a good job in explaining the nuances of the scheme.

The basic idea behind auto sweep is that banks allow you to take advantage of the money lying “idle” in your account by giving you a facility where they automatically move money from your savings account to a fixed deposit of a certain maturity like 180 days, and then pay you a higher interest on that part of the money that’s in the fixed deposit.

I see that Axis bank calls this scheme Encash 24 and they automatically create a fixed deposit of 180 days if your balance goes over a threshold.

Currently, the savings account rate is 4% and the 180 day rate is 7.5%, so you stand to gain the difference of 3.5% from their auto sweep facility.

I haven’t seen a bank charge for this, and some banks reduce the interest they give you by a percentage if you break the fixed deposit before the maturity, but that is still one or two points higher than what you would have gotten otherwise.

Like I said in the post about the highest savings account interest rate – the extra interest income you make on this should not be big enough to make a meaningful difference to your overall returns and you shouldn’t spend too much time worrying about this.

Instead, if you do indeed find that a lot of your money moves from savings to fixed deposit or that you have money lying in your savings account that you don’t often use then just create a special fixed deposit in one of the high interest rate banks and really put it to work.

How is the Sensex calculated?

The Sensex is one of the most widely followed index in India, and in this post we are going to look at how the Sensex is calculated.

The Sensex is constructed using the free float methodology, which simply refers to a company’s share capital that is freely available for trading.

You know that market capitalization is the number of shares that a company has multiplied by the price per share, so when they say that Coal India has become the most valuable company in the country – this is what they refer to.

Free float is that part of the company’s capital that’s not held by promoters, governments or other strategic investors and is available to trade on the stock exchange freely.

Now, the free float market capitalization method simply means that the company with a higher free float will have a higher weight in the index, and a great way to understand is to just take a look at the Sensex constituents for a particular date.

In this table I’ve taken the data as it stands on November 4th 2011.

Scrip Code Company Close Price No.of Shares (normal) Full Mkt. Cap.

(Rs. crore)

Free-Float Adj. Factor Free-Float Mkt. Cap

(Rs. crore)

*Weight in Index

(%)*

500325 RELIANCE 879.6 3274230107 288001.28 0.55 158400.7 10.97
500209 INFOSYS LTD 2829.1 574203082 162447.79 0.85 138080.62 9.56
500875 I T C LTD 210.35 7773036720 163505.83 0.7 114454.08 7.93
532174 ICICI BANK L 885.2 1152447612 102014.66 1 102014.66 7.06
500010 HOUSING DEVE 682.9 1469093501 100324.4 0.95 95308.18 6.6
500180 HDFC BANK LT 482.1 2335493765 112594.15 0.8 90075.32 6.24
500510 LARSEN & TOU 1392.85 611161097 85125.57 0.9 76613.02 5.31
532540 TCS LTD. 1099.1 1957220996 215118.16 0.3 64535.45 4.47
500112 STATE BANK O 1964.25 634998991 124729.68 0.45 56128.35 3.89
532454 BHARTI ARTL 397.95 3797530096 151122.71 0.35 52892.95 3.66
500312 ONG CORP LTD 277.65 8555490120 237543.18 0.2 47508.64 3.29
500520 MAHINDRA & M 835.05 613974839 51269.97 0.8 41015.98 2.84
500696 HIND UNI LT 378.85 2160326258 81843.96 0.5 40921.98 2.83
500570 TATA MOTORS 188 2691485485 50599.93 0.7 35419.95 2.45
500470 TATA STL 467.9 959214779 44881.66 0.7 31417.16 2.18
532555 NTPC LTD 179.55 8245464400 148047.31 0.2 29609.46 2.05
500103 BHEL 333.65 2447600000 81664.17 0.35 28582.46 1.98
532977 BAJAJ AUTO 1743.1 289367020 50439.57 0.5 25219.78 1.75
532286 JINDAL STEEL 577.3 934509595 53949.24 0.45 24277.16 1.68
507685 WIPRO LTD. 371.55 2457457840 91306.85 0.25 22826.71 1.58
524715 SUN PHARMACE 511.55 1035550385 52973.58 0.4 21189.43 1.47
500182 HEROMOTOCO 2116.2 199687500 42257.87 0.5 21128.93 1.46
533278 COAL INDIA 326.35 6316364400 206134.55 0.1 20613.46 1.43
500440 HINDALCO IN 139 1918551613 26667.87 0.7 18667.51 1.29
500900 STERLITE IN 123.15 3360700478 41387.03 0.45 18624.16 1.29
500400 TATA POWER 103.3 2373072360 24513.84 0.7 17159.69 1.19
532500 MARUTISUZUK 1123.35 288910060 32454.71 0.5 16227.36 1.12
500087 CIPLA LTD. 293.7 802921357 23581.8 0.65 15328.17 1.06
532868 DLF LIMITED 246.8 1698001797 41906.68 0.25 10476.67 0.73
532532 JAIPRAK ASSO 79.25 2126433182 16851.98 0.55 9268.59 0.64

Notice how there is not much difference between the market capitalization of  Reliance and Coal India relative to their weight in the Sensex. One has a weight of almost 12% while the other has a weight of just 1.43%.

The difference is due to the fact that while most of Coal India is owned by the government, most of Reliance is owned by the general public and has a much higher free float as a result.

You will also see that there is a column called Free Float Adj Factor there which indicates what fraction should the total market capitalization be multiplied with to come up with the free float market capital to be considered in the Sensex calculation.

So, they just don’t say this company has a free float of 42.5% so let me multiply its market cap with .425 but rather they have slabs and decide how much to multiply the total market capitalization based on which slab it falls under.

Here is the table that shows the slab:

% Free-Float

Free-Float Factor

% Free-Float

Free-Float Factor

>0 – 5%

0.05

>50 – 55%

0.55

>5 – 10%

0.1

>55 – 60%

0.6

>10 – 15%

0.15

>60 – 65%

0.65

>15 – 20%

0.2

>65 – 70%

0.7

>20 – 25%

0.25

>70 – 75%

0.75

>25 – 30%

0.3

>75 – 80%

0.8

>30 – 35%

0.35

>80 – 85%

0.85

>35 – 40%

0.4

>85 – 90%

0.9

>40 – 45%

0.45

>90 – 95%

0.95

>45 – 50%

0.5

>95 – 100%

1

The next thing to look at are the weights, and it’s obvious that the way the index has been constructed – the weights change every second because price is an input for how much a stock will influence the Sensex, and that changes every second.

I have been recording the percentages for a few days to write this post, and here is a result from the past few days.

Nov 1 2011

 Nov 2 2011

 Nov 4 2011

 Company

Weight

 Company

 Weight

 Company

 Weight

RELIANCE

10.78

RELIANCE

10.93

RELIANCE

10.97

INFOSYS LTD

9.63

INFOSYS LTD

9.61

INFOSYS LTD

9.56

I T C LTD

7.88

I T C LTD

7.93

I T C LTD

7.93

ICICI BANK L

7.18

ICICI BANK L

7.12

ICICI BANK L

7.06

HOUSING DEVE

6.64

HOUSING DEVE

6.62

HOUSING DEVE

6.6

HDFC BANK LT

6.27

HDFC BANK LT

6.29

HDFC BANK LT

6.24

LARSEN & TOU

5.32

LARSEN & TOU

5.31

LARSEN & TOU

5.31

TCS LTD.

4.52

TCS LTD.

4.52

TCS LTD.

4.47

STATE BANK O

3.78

STATE BANK O

3.8

STATE BANK O

3.89

BHARTI ARTL

3.65

BHARTI ARTL

3.56

BHARTI ARTL

3.66

ONG CORP LTD

3.31

ONG CORP LTD

3.32

ONG CORP LTD

3.29

HIND UNI LT

2.92

HIND UNI LT

2.94

MAHINDRA & M

2.84

MAHINDRA & M

2.85

MAHINDRA & M

2.87

HIND UNI LT

2.83

TATA MOTORS

2.54

TATA MOTORS

2.52

TATA MOTORS

2.45

TATA STL

2.2

TATA STL

2.19

TATA STL

2.18

NTPC LTD

2.04

NTPC LTD

2.02

NTPC LTD

2.05

BHEL

1.9

BHEL

1.89

BHEL

1.98

BAJAJ AUTO

1.73

BAJAJ AUTO

1.73

BAJAJ AUTO

1.75

JINDAL STEEL

1.63

JINDAL STEEL

1.64

JINDAL STEEL

1.68

WIPRO LTD.

1.6

WIPRO LTD.

1.6

WIPRO LTD.

1.58

HEROMOTOCO

1.49

SUN PHARMACE

1.46

SUN PHARMACE

1.47

SUN PHARMACE

1.46

HEROMOTOCO

1.45

HEROMOTOCO

1.46

COAL INDIA

1.45

COAL INDIA

1.44

COAL INDIA

1.43

STERLITE IN

1.3

STERLITE IN

1.3

HINDALCO IN

1.29

HINDALCO IN

1.27

HINDALCO IN

1.27

STERLITE IN

1.29

TATA POWER

1.17

TATA POWER

1.18

TATA POWER

1.19

MARUTISUZUK

1.14

MARUTISUZUK

1.13

MARUTISUZUK

1.12

CIPLA LTD.

1.05

CIPLA LTD.

1.05

CIPLA LTD.

1.06

DLF LIMITED

0.7

DLF LIMITED

0.7

DLF LIMITED

0.73

JAIPRAK ASSO

0.62

JAIPRAK ASSO

0.62

JAIPRAK ASSO

0.64

This is an important point, and is something that most people aren’t able to wrap their heads around in the first time. When you think about weight of a stock in the Sensex you think of it as a static value like Reliance has 12%, ICICI Bank has 7% and so on, but that is not true because the weight changes every second as the price changes. In this table I have highlighted two companies whose relative importance changed from one day to another in the Sensex.

So, the weight shows you much the stock is currently worth to the Sensex but that is not a static value, and will change every second.

With those things out of the way – now think of the utility of the Sensex – why do you need the Sensex at all?

Like any other index – it tells you how the stock market is performing at any given time – a higher Sensex means share prices are higher, and a lower Sensex means share prices are lower and that share price movement is captured in the form of free float market capital in the Sensex.

To maintain continuity and make the number comparable across time – the Sensex had to have a base – and that base was the market capital of the stock market in 1978 – 79 and the base index value of the Sensex was 100. The value that you see today is the sum of the free float market capital of the thirty companies relative to the base market capital.

The base is not a static value but keeps changing because they need to account for special events like rights issue, bonus issues, change of companies in the index so that these special events don’t affect the continuity of the index.

Based on the market data that I have seen for the past few days I have calculated the current base market capitalization as Rs. 8,221.94 crores.

Formula to calculate the Sensex

The formula to calculate the Sensex is as follows:

(Sum of Free Float Market Capital / Base Market Capital ) x 100

You can get the sum of free float market capital very easily from this page, however this changes every day so you need to save it with you if you need to refer to it later.

For this post – I have saved the data in my spreadsheet.

Let’s look at some of the past data:

Nov 1 2011 (1,437,262.79 / 8221.94) x 100 = 17,480.83

Nov 2 2011 (1,435,949.06 / 8221.94) x 100 = 17,464.84

Nov 7 2011 (1,443,986.58 / 8221.94) x 100 = 17,562.60

Nov 8 2011 ( 1,444,556/ 8221.94) x 100 = 17,569.53

Nov 9 2011 (1,427,501.45 / 8221.94) x 100 = 17,362.10

You can quite easily calculate the Sensex any day by just going to the BSE Website, and getting the total market free float and putting it in this simple formula. If it doesn’t come up correct, then that means the base market capital has been changed and you need to back calculate that and test it out on a few days to make sure that you have the right base market capital and then use it to calculate the Sensex in the ensuing days.

Once you understand all the inputs that go into the calculation it becomes fairly simple to calculate the final Sensex value, but probably more important than calculating the value is to understand the mechanics behind it and what it’s trying to show to you.

As always, questions and comments welcome – especially if there were some parts that you thought were not clear enough and need more explaining.

This post is from the Suggest a Topic page.

Power Finance Corporation Secured Tax Free NCD Issue

Shiv left a comment about PFC coming out with an issue of tax free bonds, and I thought it will be a good idea to do a quick post on them.

These bonds have a face value of Rs. 1 lakh so they are priced out of range for a lot of people, but otherwise with an interest rate of 8.09% for the 10 year bond, and 8.16% for the 15 year bonds – the yields are pretty good especially if you are in the 30% tax bracket, and these bonds will later on list on the stock exchange so that means you will have the ability to sell them at the exchange later if you don’t want to wait till the maturity.

For whatever it’s worth the issue has also been rated AAA by CRISIL and ICRA and PFC itself is a Navratna of course.

The PFC tax free bond issue opened on the 2nd November, and will close on the 25th November 2011.

Here are the interest rates and effective yields for both the maturities.

Maturity Period

10 years

15 years

Interest Rate

8.09%

8.16%

Effective yield for people in 30.9% tax bracket

11.71%

11.81%

Effective yield for people in 20.6% tax bracket

10.19%

10.28%

Effective yield for people in 10.3% tax bracket

9.02%

9.10%

The interest is going to be paid every year on the 25th November.

Incidentally, someone emailed me the other day asking if there was a calculator to calculate the effective yields for tax free bonds, and while I have never seen a calculator to do this – it’s fairly easy to calculate it yourself.

Effective yield simply implies what coupon rate would you need to match this bond if it weren’t tax free.

For instance, if you got a fixed deposit for 11.71% per year then at the end of the year you would have to pay a tax of 30.9% on 11.71 i.e. 3.62 and you will be left with only 8.09 after tax.

So, the tax free yield of someone at the 30.9% tax bracket of the 8.09% bond becomes 11.71%.

The formula for this is fairly straightforward:

Effective Yield  = {Interest Rate / (1 – Tax Rate)}

I’m not quite sure how you go about buying these bonds except for approaching someone like Shiv (who is a financial adviser based out of Delhi, Contact Number: +91-9811797407, Email Address: ojascap at gmail.com), or perhaps calling up your local advisor so I won’t be able to comment on that aspect of it. If you have invested in these in these type of issues in the past then please let me know and I’ll update the post.

Once again, thanks to Shiv for bringing the PFC tax free bond issue to my notice, and all questions and comments are welcome!

Difference between shares and mutual funds

The best way to understand shares and mutual fund is to look at them from the perspective of the company that issues them rather than an investor. This may sound counter – intuitive at first because almost everyone tries to figure out what they mean from the perspective of an investor but somehow I find it a lot easier to explain them from the other perspective, and I think it will work for you as well.

What are shares?

Let’s say I run a space tourism company and run trips to the moon. I have had a successful business so far but I need some Rs. 100 crores for further expansion and invest in technology that will help me launch space trips to the Mars.

I own this company and I can raise the money by either going to a bank for loan or raising money from the public by issuing them shares in my company which will guarantee them a share of ownership in the company.

Let’s say my whole company is valued at Rs 500 crores, and that means I can issue 20% of my company’s shares to the public at Rs. 100 crores.

This is essentially what an IPO or Initial Public Offering is where a company comes out with an offer of its shares to the general public for the first time. A Follow On Public Offer or FPO would be when my company comes to the market for a second time.

Now suppose I do the IPO of my company and you buy shares worth Rs. 5 crores in the IPO – that will give you ownership of 1% of my company with voting rights equivalent to 1% and rights on the profits of 1% of the company.

In real life, common investors hold a lot lesser than 1% of a company and that’s why you rarely ever think in these terms but when you own a share – this is exactly what you own.

After the IPO – the shares of my company will trade in a stock exchange like the NSE or BSE, and people can buy or sell the shares from the stock exchange. In order to buy or sell these shares they will need a stock trading account and a Demat account.

Now, you must remember that when you buy a share in the IPO or FPO you buy it from the company, but when you buy it later on in the stock exchange you buy it from another investor or trader like you and that’s the reason this is called a secondary market.

The next thing to remember is that while you will continue to hear that I own the company, that’s not entirely true – I own only 80% of the company, and the rest of the 20% is owned by other investors like you.

Sometimes when a fraud is committed at a company – you can hear people say why did he steal from his own company?

And the answer is because it was not his own company!

While he may be running the company, he may only be an owner of 25% of the shares, and thereby only 25% of the earnings, and therefore he never had a right to the other 75% of the profit.

The other silly thing that I’ve heard from time to time is when someone criticizes really rich people like Azim Premji for calling their wealth “paper wealth”.

What people like Premji mean is that the wealth reported by magazines is based on share price, and these share prices keep fluctuating so the wealth keeps fluctuating as well. And anyway most promoters don’t have any intention of selling their shares so it’s all on paper anyway. This is not an arrogant statement, it’s just based on the fact that wealth is calculated based on fluctuating share prices that’s all.

Now, let’s get back to our original example and say that you tell your wife about the shares you buy in my company for Rs. 5 crores, and she is furious with you and says that this is a hare brained idea, and that you can’t bet all your money in just one company that may blow up any time!

You realize your mistake because after all if my Mars mission doesn’t get successful my company will go bankrupt and that will render your investment worthless.

So, you sell Rs. 2.5 crores worth of shares on the stock exchange and get that cash. Now, remember me or my company never get this money, somebody else like you bought it from you.

Now, you take this money and buy shares of my competitor company who is planning trips to Venus and you are feeling pretty proud of yourself and go to tell your wife about your latest strategy.

She is of course furious with your whole obsession with the space travel industry and asks you what will happen if the whole industry fails and every company goes bust?

You’re hit by a lightning bolt as you think about real estate stocks and IT stocks before them, and you decide to buy more companies.

But you don’t have the time or patience to go through the thousands of companies listed on the stock exchange to select an investment worthy one from it.

What are Mutual Funds?

This is where mutual funds come in.

They take money from thousands of investors like you and invest in stocks on your behalf. They hold many companies so that even if one is gone – you don’t lose all of your money.

They charge you a fee to manage these funds, and that’s expressed as something called as an “Expense Ratio”. This is a percentage of assets that they can use to cover their expenses and make profits, and the lower this is the better it is.

Mutual funds buy shares of companies, and they can calculate the value of their holdings by aggregating all the shares they have, and at the end of every day they publish a number called Net Asset Value or NAV. This is the value of the fund and how much it is worth at that point in time.

You have to buy or sell mutual funds directly from the fund house, and you can’t buy or sell them from another investor on the stock market like shares of a company.

Mutual funds are based on themes and are of different types but the main idea behind them is that they are an investment vehicle that help you spread out your investments in the underlying theme or asset class.

Another thing about them is that mutual funds are actively or passively managed. Actively managed means that there will be a fund manager who buys and sells stocks actively, and looks out for opportunities to buy and sell in the market all the time.

Passively managed funds are funds that just follow an index like the Nifty or the Sensex, and don’t try anything fancy. They own the same stocks as the ratio of their index and are content with matching their returns.

These type of mutual funds were born because research shows that most active funds aren’t even able to beat an index so it just makes sense to bring out a lower cost option that at least matches the index returns. However, they still do a better job than owning a few shares on your own and risk blowing up your capital if one of the companies go bust.

I think this covers the basic differences between the two and here is another post that goes into more details on how mutual funds work if you are interested in learning more about them.

As always, questions and comments are most welcome!

This post was from the Suggest a Topic page.

LIC Whole Life Limited Payment Policy Review

LIC Whole Life Limited Payment plan is an insurance policy that covers your life, and then at the time of maturity it pays you out a certain amount as well.

Technically the policy doesn’t mature because it is whole life assurance (and by this I mean I’m just repeating what their website says) but you get the sum assured plus all the bonuses 40 years from the date you start the policy provided you are 80 years old at the time.

So, if you are 39 years or younger you will only get the sum assured when you are 80, and if you are 40 or older then you will get the money in 40 years time.

You have the option of different premium payment terms in this plan – you can pay the premium just once at the beginning of the plan, pay it annually, pay it for 10 years or structure it in some other manner.

The insurance will last throughout the life time of course, and at age 80, you are guaranteed to get the sum assured back plus some variable returns based on the returns that LIC themselves generate.

These are variable and depend on what LIC earns way into the future.

I created a Google Spreadsheet to look at the IRR of these returns based on the illustrations of LIC and they range from 3.66% to 6.47% for the two options with periodic investments and from 4.5% to 7.5% for the one time investment.

These are of course all examples, and nothing is guaranteed in this. Here is the spreadsheet that you can look at and modify as well. Now, these are actually not bad returns when you think about the other products that we have reviewed here, but the trouble is with the relatively low sum assured, and how far out in the future the payment is made.

Vishal who brought this product to my notice said that his agent sent in a quote for a Rs. 35 lakh term insurance for Rs. 13,500 for 35 years, and he asked Vishal to take a look at this LIC Whole Life Payment policy where you pay Rs. 26,000 for 40 years to get a sum assured of Rs. 10 lakhs, and get Rs. 80 lakhs at the end of 40 years. That 80 lakhs is of course based on assumptions and for us I think it’s fair to think that the returns will be within the 3.5% to 6.5% range for this policy.

From the quotes that Mr. SM Gupta had shared on various sample term insurance plans, we know that you can easily get a policy of Rs. 25 lakhs from private players for a little more than Rs. 5,000 and you can then combine that with a policy from LIC to get additional coverage.

If this is the only insurance you’re going to get then that’s a bad idea, but if you have an insurance with a private insurer and want to supplement that with something from LIC then you may consider this keeping in mind the factors that we have talked about above.

This post was from the Suggest a Topic page