Diversification will reduce your profits

Diversification is the mantra for reducing exposure to risk in the markets. What this also means is that the potential to make sizable profits in the markets go down.

Don’t get me wrong, I am all for diversification. But, when diversifying, you should understand the fact that by putting your eggs in different baskets, you are reducing the chance of any one of them making your basket grow much bigger than it currently is.

Most people do not treat their stocks as companies that they own, and therefore are not able to think through “diversification” properly.

Let me give you an example of thinking through diversification. When I was going through annual reports of companies that produce capital goods, a common risk I noticed was rising input prices.

All these companies said that they had very little control over raw material prices and any rise in them will impact profitability.

So, the next thing was to find out what raw material they were talking about?

No surprises here, all the companies were using steel as one of the primary inputs and a rise in steel prices posed a big threat to their profitability.

Now if you have three stocks in your portfolio that use steel and the rising price of steel is posing a threat to their profitability, you should probably go out and buy yourself some good steel stock. That one purchase diversifies three stocks that you have.

If you think about stocks as businessses that you own, it becomes easy to diversify. After buying the steel stock, I realized that most of the portfolio was favoring capital goods and machinery and I did not have a lot of stocks that will benefit from retail buying.

So I went out and bought a fast growing retail chain store of India. That had me diversified across sectors. Doing this exercise a few times over helps you get a good perspective on your portfolio and how diversified you are.

The important thing is to think of your stocks as businesses and think about how they make their money. Once you think in that direction, it is easy to see which other businesses will profit, if this one was going down. Then go ahead and buy some stock of the leader in that business.

Researchers have come to the conclusion that if you select around 20 stocks carefully, you are diversified enough. Any more stocks after that number do not protect you from losses to a greater degree.

So, the bottom line is to think like a business owner and not over-diversify.

What should I look for in a home equity line of credit?

When looking for a Home Equity Line of Credit, there are several factors that you need to consider. These include the terms of repayment, interest rate and other fee etc..

Let us take a look at the major factors that you should consider when thinking about taking out a home equity line of credit:

  1. Application Fee: Ideally there should be zero application fee while taking out a home equity line of credit. However, if you are not able to get a deal with a zero application fee, make sure that the fee you are paying is refundable when the line of credit closes.
  2. Interest rate: If you are being charged a variable APR, then that APR will be expressed as prime plus 2% or prime plus 3% etc. This means that the lender will charge you two or three percent over the prime rate. Look for the lowest interest rate possible.
  3. Appraisal fee: In order to determine what is the right price for your house, the lender will need to appraise your property. Lenders should absorb this cost and you should not be required to pay any fee for this.
  4. No usage fee: No usage fee means that if you are not using your home equity line of credit, you end up paying a fee to the lender. This is not a good thing at all and  you should avoid this completely
  5. Maximum APR: If you are availing a variable APR, then your bank will have the option to increase the APR as the prime rate increases. You should check whether there is a cap on this at all. Ideally there should be a cap on the maximum APR that you can be charged.
  6. Repayment Terms: Examine the terms of repayment carefully, some lenders allow you to make payments only towards the interest while the home equity line of credit is active. This is not a good thing and you should be able to repay principal also. Additionally some lenders put a penalty on borrowers who pay extra principal. You should bargain to get this penalty waived. If it is not waived, then you should at least be aware of it and try to reduce it as much as possible.
  7. Introductory Rate: Like credit cards, home equity line of credits also come with an introductory rate. Be sure to ask for an introductory rate on your loan.
  8. Closing costs: There are several costs that are associated with closing a line of credit. You need to be aware of the various options available to you. You can also go in for a plan which has no closing costs, but that has other riders attached. There are also plans that deduct the closing costs from your line of credit. Explore your options and choose one that suits you the most.

Since your house is one of your biggest assets, any decision that puts your house on the line needs to be taken carefully. Use these parameters to select the best home equity line of credit option for you.

Congratulations to Obama and Democracy

In a few months, United States will have a new president and President Obama will start writing a new chapter in the history of United States and, perhaps, the world.

Democracy and Capitalism are two ideologies that are very close to my heart. Growing up in one of the most vibrant democracies in the world, and debating in the great colleges of Delhi University, I came across many arguments for and against Democracy and Capitalism.  I devoured “Das Kapital” and loved every page of “The Wealth of Nations”.

As I learned more, I was convinced that the principles of Democracy and Capitalism are the only means to deliver Liberty, Fraternity and Equality to all mankind.

I still remain firm in my belief.

Democracy has already shown its power today and while the world may be losing its faith in Capitalism, in the years to come, that faith will be restored too.

My congratulations, from one great democracy to another.

Manshu Verma

Should I take a home equity loan?

Home Equity Loan is a lump sum loan taken out on your home equity. Home Equity Loan is a second mortgage that has become quite popular with home-owners, as they saw the value of their homes appreciate steadily during the housing boom.

The lesson from the housing crisis is that you should not take a home equity loan for any expense that will not generate returns. For example, a kitchen renovation or a long due holiday are not good enough reasons to take out a home equity loan.

On the other hand, college education for your children is a good enough reason to take out a home equity loan.

Here are some factors that you should consider when thinking about a home equity loan:

  1. Has the value of your house risen substantially? Like any other assets, housing prices are also cyclical in nature. If the value of your house has risen substantially in the past few years, then there are good chances that they will come down in the future. Consider this and take out a loan that is substantially lower than your maximum limit.
  2. How will you repay for your home equity loan? A lot of home equity loans have options to pay very little during the duration of the loan. At the end of the term, you will either need to make a balloon payment or refinance the loan. Such terms and conditions are fertile grounds for getting into perpetual debt. If you don’t have a good plan of getting out of this debt, then it is wise to stay away from it.
  3. Do you plan to rent out your home? Some home equity plans prevent you from renting out your home. So if you were considering renting out, then make sure you check whether the bank will allow you to rent out, once you take the home equity loan.
  4. Purpose of the home equity loan? If you are planning to take the home equity loan for an expense like a vacation or a renovation, then it is better to avoid it. The house is the most valuable asset for most families, therefore tapping into it for expenses that can be avoided, eats into what could be your “rainy-day” money.
  5. Are you willing to put your house on the line? The current spate of foreclosures should make this point really obvious to all. Since, your house acts as a collateral in a home equity loan, the bank can seize your house and sell it, in case of default. So be sure that your ability to repay the loan, amount of the loan and the current market prices are balanced and one of these factors do not create a condition where you may face foreclosure.

These are just some questions that you need to ask yourself, when going in for a home equity loan. Home equity loans are a great souce of money when you really need it. Since, the collateral is your house itself, be sure that you really do need the money.

What is Home Equity Line of Credit?

Home Equity Line of Credit is like a credit card loan. That means that you can borrow money up to a certain level, based on your home equity.

How is Home Equity Line of Credit calculated?

In theory, Home equity limit is determined by the amount of money that you will have in your pocket if you sold your house today.

Here is an example:

  • Current appraised value of your house:         $150,000
  • Less: 15% Margin for any depreciation:          $22,500
  • Less: Amount you owe on your mortgage:     $27,500
  • Your Home Equity Line of Credit:                   $100,000

In the above example if you sold your house today, it will sell at a $150,000 and you still owe $27,500 for your mortgage, so the amount that is really yours, will be $122,500. To be safe, banks will reduce the available loan by a safety margin (15%, in our example). So, even if the price of your house goes down, the bank is cushioned.

The major factor determining the home equity line of credit is the market price of your house.

If the value of your house is goes up, you will have a lot more money available to you as your home equity line of credit. And if the value goes down, the available equity line of credit also goes down.

How is home equity line of credit like credit card debt?

Like credit card debt, home equity line of credit offers you a line of credit that you can access any time. So if your home equity line of credit has been determined as $100,000, you do not have to take out all the amount right at the start, or at specified intervals. You can use the money as and when you need it.

Your bank will extend this line of credit to you for a period of 10 to 15 years after which the terms and conditions will be renogitiated based on the market conditions.

Since a home is one of the biggest asset that most families have, the loan from a home equity line of credit should be used very carefully and wisely.

Will I be sued for credit card default?

The short answer to this is Yes. Even though credit card debt is not secured debt, you can be sued for defaulting on credit card debt and be taken to court.

Once in court, they can garnish your wages. While the rules for taking you to court depends on the state that you are in, generally, most states do allow creditors to take the debtors to court for credit card debt default.

There are several instances where credit card companies have taken debtors to court for credit card defaults of amounts as small as $4000.

What happens if I am taken to court for credit card debt default?

While the specifics depend on your situation, what we describe below is a real life situation that a lot of people have already gone through. So, while most people treat this scenario as the worst case scenario, it is one, that can really occur.

If your credit card company sues you and takes you to court, you will not get a real trial. That means that you will just be asked to verify your identity and asked whether you really incurred those debts. If you answer in the affirmative, then the trial will be over then and there. The judge can ask your wages to be garnished and add the cost of the courts and attorneys to the debts. This amount will then be deducted from your salary every month. As you can well imagine, this becomes a socially embarrassing situation as you will need to explain the condition to your HR department and your coworkers will eventually learn about it.

What is the best thing to do if I know I can’t pay my debts?

If you want to eliminate all chances of going through the hell we described above, call your credit card company and explain your situation.

The credit card companies want their money and they may be willing to freeze your interest going forward and chalk out a payment plan with you. This is very often the best scenario for a lot of people who can’t afford to pay their debts any longer. They may even waive off your fees.

The specifics will depend on your situation, but it is better to call your credit card company and find out your alternatives before stopping payments altogether.

Act Now

If you find yourself in a situation where you may not be able to make payments, do not procrastinate, act immediately. If you wait too long, you may find yourself in a position from which it is difficult to recover. Once you default on your credit card payments, it will go to the collection agencies. The collection agencies make life really difficult by calling up work and home and creating embarrassing situations.

The default will also appear on your credit report and will ruin your credit score.

It is better to avoid all this and act quickly and decisively. This way, even if your situation worsens, you will be fully aware of what is going on in your life and will not be left second guessing on what happens next.

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