Look beyond returns on your investments

While it is important to know what you are earning on your investments, you must also understand the nature of the return and align it to your financial goals

Sunita Abraham 

What is the return?” is the most important question for people looking to make an investment decision. While there is no taking away the importance of earning an adequate return, the suitability of an investment for the needs that it is expected to fulfil goes beyond just this number.

Consider the difficulty of trying to fund a fixed regular payout to meet college expenses out of equity investments, or to build a retirement corpus purely from low-risk debt investments. It is important, therefore, to also understand the nature of returns offered by an investment and align it to the needs of the goal. A mismatch between the two may well lead to a situation where the goals remain unmet.

The interest and the dividend

There are two broad types of returns that an investment will provide. One, is the periodic return that an investment may pay to the holders. Think dividends, interest and rental income and you know the comfort and advantages of receiving some returns periodically, while still retaining the investment. There are differences in the nature of periodic income too. You know the amount of interest income you will receive and its periodicity at the time of buying a debenture or making a fixed deposit. This reduces the uncertainty and makes it a suitable source of income for goals that require a pre-determined payout.

Interest income has to be assessed for risk of default by the entity liable to pay the interest due. Interest income that is guaranteed, such as interest income earned on government-sponsored savings schemes or secured by creating a right on the assets of the issuer—like a secured debenture issued by a company—has lower levels of risk and this translates into lower returns too. Interest income is fixed for the period of investment, and traditional fixed income investment products do not give you a chance to earn higher interest income with a rise in inflation or general interest rate trends in the economy, once you are invested.

On the other hand, while you may go for years without receiving a dividend on your equity investments, there is also the possibility of higher dividends as the performance of the issuer of the instrument goes up. The level of dividend is higher when the profitability is high, and vice versa. Unlike interest income, the rate of dividend or the amount of dividend is not known at the time of making the investment. This feature of dividend income makes it risky to depend upon to meet a fixed expense.

Rental income earned on real estate holdings have some degree of predictability for the period of the lease or rental agreement. Rental income also has the advantage of keeping pace with inflation, unlike interest from fixed income securities. However, there may be periods when the property lies vacant when there is no income earned on the investment.

Sell for capital gains...or loss

Capital gains are earned when an investment is sold or redeemed at a value higher than what was paid at the time of making the investment. Investments in equity and debt securities, real estate, gold and other commodities, mutual fund units and others have the potential to appreciate in value and generate capital gains. But this also means that there is the possibility that the values may decline and the investor may make a loss. This feature of the return from such investment implies that the investor must have the skill to make the right selection and monitor the investment. Holdings in real estate also suffer from the drawback of not being amenable to being sold in small units to meet the need for funds. Investments where the capital gains constitute a large component of the return are best assigned to goals that have an adequate time horizon required for the investment to appreciate in value.

Some investments may feature only periodic income, such as deposits with banks and Public Provident Fund. Some investments may feature only returns in the form of gain in value that can be realized when the asset or investment is sold. These include investments like gold and other commodities. Many investments offer a combination of both types of returns. For example, in the case of equity investments, both dividends and capital gains contribute to the total returns earned.

Similarly, rental income and appreciation in the value of the property contribute to the returns from real estate investment. Greater the contribution of capital appreciation to the total returns from an investment, greater will be the volatility and perceived risk in the investment, and they should be assigned to goals that gives the investment the time necessary to recover from any downtrends.

Give to tax

The nature of the return earned on an investment also has a tax implication and therefore on the portion of the return that is actually available to the investor to use. Dividend income earned from equity investments is exempt from tax in the hands of the investor, while periodic income earned as interest or rent is taxable at the marginal rate of tax applicable to the investor. The tax on capital gains depends upon the period of holding before the investment was sold to realize the gains. Short-term capital gains are taxed at the higher levels of tax depending on the income level of the investor, while long-term capital gains are usually first adjusted for the effects of inflation before it is taxed, which brings down the tax payable. Understand the nature of return from an investment and then decide the role they will play in your investment plan.

Source : livemint