New Income Tax regime and the Intelligent Investor – Reading between the lines

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Reading Time: 19 minutes

The old tax regime was introduced in the 1960s to incentivise savings and investment. As we progress as a matured economy and more people become aware of personal finance, it is natural and sensible to shift towards a flexible rate structure. It has to be simple and make the decisions related to tax incentives easier for the common man to understand. For the matured investors, it should allow them to choose between existing rates with incentives or a flat low rate without incentives. As a country, we need to evolve into investment mentality from the existing tax saving behaviour. The Govt. announced a new tax regime in the 2020 Budget on February 1st. Is it any good? Are we a matured economy yet?

The Good:

An individual has 2 options now – Pay old tax rate with incentives or pay new lower tax rate without incentives.

Lower tax rate will put more money in the hands of the individual which will lead to increased spending. This will boost the economy.

People will not buy the shady ULIPs and insurance products anymore for the sake of tax planning (they might still buy Term Insurance).

Flexibility and ease of filing for the following people:

  1. The ones who do not have or have finished their education / housing loan.
  2. The ones who invest in the equity markets by themselves or through mutual funds and don’t want to go through the ELSS / PPF / NPS route.

I have made a basic calculator to check your tax and decide if one should stick to old regime or shift:

https://drive.google.com/file/d/1GLpZme3SySnjgTD2rPVzHNM3z8IOw6fd/view

The Bad:

The ones who avail exemptions and deductions end up paying more tax if they move to the new regime.

People will now have to take the support of professionals to decide if they have to stay or switch because of the complex nature. It is definitely not simple.

An individual with a salary of 12.5 Lakhs will end up paying Rs. 30,500 more under the new rates. He will have to pay more if he has education or housing loans. They should stick to the old regime till they are done with their exemptions.

(Use the calculator above to play around)

Ms Sitharaman said while the intention this time was to “reduce rates and simplify structure”, the government “will be able to gradually remove all exemptions”.

https://www.ndtv.com/india-news/government-plans-to-remove-all-income-tax-exemptions-in-the-long-run-says-nirmala-sitharaman-2173229

So the Govt. will eventually force everyone to shift to the new tax regime where there is no incentive for savings at a time when savings as a % GDP is at rock bottom. We are actually spending from savings AND taking loans (vehicle, credit card, EMIs). And the new tax regime will only add fuel to the fire.

Why do I feel that people will spend more with the extra cash rather than saving it? Indians lack awareness, discipline and financial knowledge.

  1. According to a survey by Standard & Poor, 76% of Indian adults are unable to understand key financial concepts
  2. Only 3% of Indians have DEMAT account (3.65 crores). (The account in which one holds equity shares)

We are not a matured economy yet. Hence, although in the right direction, this new regime is a bit early for our country.

The Ugly:

If Government is expecting people to be disciplined and take care of their own savings and investments, they should at least help the cause. They are destroying the financial product which will help us beat inflation – Equity Capital Market (Shares & Mutual Funds).

A company can raise capital needed for business in 2 different ways – Debt and Equity. Similar to individuals taking loan from banks, companies take loans from banks and investors. This is the debt part. The returns for them is the interest paid by the company on these loans. Or the company can issue shares (IPO, FPO) for a certain price (part ownership of business) to investors and offer them 3 types of returns:

  1. Capital Gains – The company invests the money taken from the shareholders in the business and tries to increase the total value of the business by growing each year. The value of the shares also increases (sometimes disproportionately, both ways) in the long run. The shareholders can sell their shares in the secondary market (IPO is the primary market, after that the shares are traded in the secondary market) for a higher price than they initially paid.
  2. Dividends – The company runs business and earns profits. After paying tax, the company can choose to invest these profits in the business for expansion. If they don’t have good opportunities to invest, they will pay some of the profits to the shareholders in the form of dividends (your share of profits) or do share buy backs.
  3. Share Buy Back – ABC Ltd. issued 10 shares to me, 10 to you and the rest 80 is held by the owners of the company. We both own 10% of the company. Now if the company decides to buy back some shares, I return my shares since I am getting a higher price than I initially paid. These shares are put in the Treasury account of the company and no longer considered as ownership. Why do companies do this? We both owned 10% each when there were 100 shares. Now that there are only 90 shares, you own 11.11 % and the rest is for owners. The value per share of the company increases which might lead to increase in prices of these shares in the secondary market.

Guess what, the Govt. made a mess in all of these 3 options.

  1. In the previous budget, they announced a long term capital gains tax of 10% for income of more than 1 Lakh from Equity shares or mutual funds.
  2. Also in the previous budget, they announced taxation on buy backs, dividend distribution tax (DDT) on companies, dividend income tax on individuals who receive more than 10 Lakh in dividends.
  3. In this year’s budget, they removed the DDT and transferred the tax burden to individuals. You have to pay tax on every rupee of dividends you receive. The 10 L limit is gone. Shareholder pays dividend tax as per his income slab and capital gains tax of 10%. The companies pay buy back tax. Tax tax tax.
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Remember. The company pays tax to government before doing any of these. Hence, this is double taxation.

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Now that the Govt. wants me to become an intelligent and matured investor, what do I do?

Invest in financial products which will help you beat the inflation and the government.

Why beat the government?

  1. It is doing everything possible to make life worse for an investor. We need to up our game. We are on our own.
  2. The returns of all the asset classes are linked to Government policies and performance of the economy as a whole.

What is Inflation and Why beat Inflation?

“Inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period of time. It is the constant rise in the general level of prices where a unit of currency buys less than it did in prior periods. As prices rise, a single unit of currency loses value as it buys fewer goods and services”

Your $0.75 in 1990 will only buy you half a cup of coffee today. Essentially, your money loses value because of inflation in prices. In finance, they call this the time value of money. To beat the inflation, you have to grow your money at a rate higher than the prevailing inflation rates. Yes, your income increases by the hike that your employer gives. But that is only for next year’s income and prices. What about the wealth that you have already generated? What about retirement where you don’t have income but there is inflation. You have to save today and grow your wealth for retirement and huge expenses like marriage, children’s education, house, car etc.

What is the current Inflation rate?

CPI Inflation Rate (overall)

It ranges between 2.5% to 12%. RBI’s target is 4%.

If we drill down further, we can see that the education and health care expenses have gone up at much higher rates.

Personal example – I did my 12th grade for a fee of 18000 in 2010. One has to pay close to 75000 even for Kindergarten today. That’s 15% growth every year!!! Did your income AND wealth grow at 15% in the last 10 years? If not, you are lagging behind.

https://cagrcalculator.net/result/

(Note – This rate might not sustain going forward. This is just to give you a perspective. Hope the government regulates both these primary sectors which are Govt’s responsibility but handed over to private players– Education and Health.)

What are the financial products available in India that will help me beat inflation?

We will start with the most common fixed income products.

Fixed Deposits:

SBI’s FD rate is 6.1%. Some private banks provide a bit higher rates. These rates keep changing based on REPO rate. The problem with FD is, the interests are taxable. Say your private bank gives you 7% and your effective tax rate is 20%, your net returns = 7% * 0.8 = 5.6%. Marginally above the average inflation of 4% and half of the education inflation.

Note – Do not deposit your money at random banks for 1 or 2% higher returns. The bank might get into issues like PMC did. Go for the bigger ones like SBI, HDFC, ICICI, Kotak if you still prefer FD.

 PPF:

The government allows you to deposit in the Public Provident Fund and gives you fixed returns. The current interest rate that you will get is 7.9%. Although, this return is tax free it has some disadvantages.

  1. Lock in period of 15 years form the date of opening account
  2. Limit on the maximum amount you can deposit every year – 1.5 Lakh
  3. The government might withdraw the tax free status of NPS
  4. Limitations in withdrawing the amount before 15 years
  5. The interest rate has been on a decreasing trend since the 1990s. From 12% to 7.9%. It might go up in the short term but in the long run, it will go down like interest rates in developed economies.  

I am ignoring government bonds as it is not easily available for everyone and are similar to FD rates.

We will look at the assets that give varying returns.

Gold:

From 2000 to 2009, Gold CAGR was 12.67%

From 2010 to 2019, Gold CAGR was 8% only

If you look at the period between 2012 and 2018, you lost time value of money! Gold can give negative returns and is volatile too.

So learn more about Gold and how it performs or affects the economy before buying it.

Disadvantages of Gold:

  1. We don’t know what makes the Gold prices move. People say, as long as humans exist the gold prices will go up. We do not know for sure. It depends on demand supply, macroeconomics, global sentiments and investor behaviour. Do millennials buy gold jewellery or even think of Gold as an investment? I don’t know.
  2. There is no underlying in gold. Like, in equity the company is the underlying. Based on its performance, the share price moves.
  3. Liquidity. If you have physical gold, it is very hard to immediately convert it to cash.
  4. In case of a dollar or rupee, when the value depreciates, the corresponding Govt. or reserve bank steps in to avoid the depreciation of their currency. But Gold is not owned by any country or any standards or governing body.
  5. Jewellery is not an investment. Liquidating gold jewellery incurs a significant loss. If you go to a bank with your gold, the bank wouldn’t pay 100% worth as the design will be outdated and redesign will result in some wastage.

Gold has given a CAGR of close to 10% since the 1980s! Is it better than Equity? I would have concluded it to be better if it had less volatility and less maximum drawdown (maximum loss from recent high). Data shows that Gold fell 20% from the highs in 2007, 2008 and every year from 2013 – 2017. So much for a safe bet, eh? If we look at the standard deviation, the long term average of yearly volatility is 25%. Which means, Gold prices can move 25% either side. Volatile! Can you bear this? Having given lesser returns with almost the same volatility and relatively less maximum drawdown, I don’t think Gold is better than Equity. Personally, I don’t prefer Gold because – no one knows why Gold moves. One advantage that Gold might(?) have is that – most of the world’s gold is in physical form and hence it is not easy to sell. So only the paper gold gets sold during market crashes which limits the downside.

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Source https://jagoinvestor.com
Source @Prashanth_Krish
Source @Prashanth_Krish

There are some people who believe that Gold is a hedge (risk protection) to all other investments. I don’t think so. For an interesting comparison, look at 2008 (biggest market crash of our time), when Gold sold off along with most other assets from March through October. But it did bottom out and started rising much before Equity.

If one wants to buy paper/liquid Gold which can be considered as proper investment as you will get market price when you sell it, there are 2 options:

Gold ETFs – https://cleartax.in/s/gold-etfs

Gold Sovereign Bonds – https://cleartax.in/s/sovereign-gold-bonds

I wouldn’t recommend more than 30% of your networth in Gold but have atleast 10 – 15%. Why?

The role of gold is not to “augment your wealth” or to provide diversification. It’s role is to protect your from what happened in Weimar Republic/Venezuela/Vietnam/Zimbabwe.

@abhishec_s

So Gold is neither a proper investment nor a hedge against Equity. It is a hedge against hyper-inflation.

Real Estate:

The ultimate goal of all Indians? “Own a damn house”

Is it really an asset? It is, if the EMI you pay for the housing loan is less than the rent you receive. According to me, if the house is not in a growing city, it is a liability. What is a liability? Any depreciating property (real or personal) like car and electronics. I would only want to buy a house for me to stay and not as an investment. Use a calculator to decide if you want to buy or rent.

https://www.magicbricks.com/advice/buy-rent-calculator-financial-advice

If you are looking at Real Estate as an investment, there are 2 ways once can make money – Rental yield and Price gain.

So what are the residential rental yields in India? (Rental Yield = Annual Rent / Value of House)

https://economictimes.indiatimes.com/wealth/real-estate/what-kind-of-residential-real-estate-can-get-you-higher-rental-return-on-investment-find-out/articleshow/68962479.cms

3 – 4%, which means you break even after 25 years!!! You might argue that one can sell the house for a higher price. Can you? Lets look at the housing prices in India.

The All India House Price Index has increased from 100 in 2010 to 250 in 2018. CAGR of 10.7%

The worrying factor is the decrease in the growth of the Index year on year. It was growing at 25% in 2010 but it was growing at a rate of only 5% in 2018.

The disadvantages of Gold are applicable to Real Estate too. You can’t sell your house or land immediately and convert to cash. We don’t know how the real estate market functions. There is the small problem of brokers, transaction and registration fees. Data reveals that Mumbai, Delhi and other metros have huge unsold inventory and the supply has dried up. It might take few years for the cycle to reverse. One can look at the property or land price movements in Hyderabad maybe or in growing Tier 2 cities. That again is difficult for an individual because how will you study the market of a different city without being there? So look at your local market. Talk to agents and try to judge the future growth and demand-supply of your city.

The major problem with gold and real estate it that there are no proven studies or strategies that will help you make informed buy or sell decisions in these assets. Let me know if you come across one. Also, capital needed for investment is huge if you want to buy a house or land.

There are new forms of Real Estate (commercial) investment:

  1. REITS – https://cleartax.in/s/reit-funds

https://www.livemint.com/money/personal-finance/india-s-first-reit-is-finally-here-should-you-invest-1552826505402.html (Minimum investment of ~ 2 Lakhs)

I have not studied land prices and there is no data available for the same.

Final Asset Class. EQUITY!!!

Study this table and find out which gave the best returns.

The ones in double digit are all equity based products. Large Cap is the top 100 public companies in India by market capitalization. Mid Cap is the next set of 150 public companies in India. Small Cap is the rest of the Top 500 public companies in India. International is the top companies in developed markets like USA. We will ignore that in this blog. Amongst the varying return products, the price movement of gold and large cap is erratic but large cap beats gold by a margin of 1.6%. This is a huge number over a longer period. Real Estate didn’t give negative returns in any year but have been declining and the process of buying a land or property is very complicated with huge initial investment. Infact, the last few years have been very bad for Real Estate. They didn’t even beat FD returns. Who knows? The real estate cycle may turn and prices might start soaring in Tier 2 cities.

How do I buy equity?

  • Direct purchase of shares. You can buy the shares of the company through brokers like Zerodha. There are 2 sciences in this regard. Fundamental Analysis (based on the performance of the business), Technical Analysis (based on the price history of the shares). This will take years and some monetary losses to master these skills. Only individuals with the know-how and experience should indulge in the direct share purchases. 
  • Mutual Funds. There are Asset Management companies like HDFC Mutual Fund and Parag Parikh which manage your money and invest in good companies on your behalf. They select companies based on Fundamental Analysis.
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What is the problem with Mutual Funds?

Risk of Selection. There are close to 300 or so Mutual Funds in India under various categories. First, you have to select the category and then choose a fund within that category. You need some skill set to do this.

Skill Set of Manager who is handling the funds. The fund manager tries to beat a chosen benchmark like Nifty 50, Sensex 30, BSE 100, Nifty 500 etc. The manager tries to achieve this by actively picking stocks that can deliver the best growth.

Costs. You pay the fund house a fee to manage your funds. It is called the expense ratio or management fees. Even if you opt for Mutual Funds, select Direct funds. Do not opt for Regular funds where the cost is high.

Impact of high expense ratio – https://www.portfolioyoga.com/wp/chart-savings-in-expense-ratio/

What is a benchmark?

An index is a representation of a part of a market. You might have heard of Nifty 50, which is one of the most widely used benchmarks. The Nifty 50 is a large-cap index that consists of the 50 biggest public companies in India. Similarly, there are various benchmarks which index various slices of the market.

Nifty 50 is a product based on certain rules and is rebalanced every 6 months.

https://www1.nseindia.com/products/content/equities/indices/nifty_50.htm

Nifty 50 companies are listed in the National Stock Exchange whereas Sensex 30 is the top 30 companies listed in the Bombay Stock Exchange. A stock exchange is the market place for buyers and sellers of shares. You will find that the Sensex companies are a subset of Nifty since most companies list their shares in both the exchanges. Similar to Amazon and Flipkart

So do fund managers beat the Index?

Across almost all the categories, your odds of picking an outperforming fund are worse than a coin toss. It means, 6.4 out of 10 funds do not even given the same returns as the Index in a duration of 10 years.

If Index beats most of the Mutual Funds, can I buy the Index?

Of course! The very purpose of this blog. Index Funds!

Performance of Index:

Nifty gave 12% returns on average in the last 15 years.

Every year the returns are different. To solve this, the average of the rolling returns is considered. Nifty long term average = 12%!

Sensex gave 12.88% in 2000 decade and 9% in 2010 decade. This is just the Price Returns Index (PRI). The Total Returns Index (TRI) will be a bit higher by 1 – 2%. PRI is only the gain in the share price of the companies in the index. The TRI includes the dividends that the companies in the Index give to the shareholders.

Comparison of Sensex and Gold
Nifty 50 PRI vs Nifty 50 TRI

The last decade returns in the Index were on the lower side due to various reasons. I am expecting the returns to be better if not same in the coming decade. Why? Usually, if a country’s real GDP grows at 6%, the nominal GDP growth is 10 – 12% (Real GDP + Inflation). The top 50 companies in India can grow at a rate similar to India’s nominal GDP growth(+- few points).

How long will India grow at high rates? Looking at South Korea for example, it grew at more than 5% for close to 4 decades.

So it is safe to assume India will be a high growth country in the next decade or two.

US markets, despite being developed and relatively low growth rates, gave 6% CAGR in the last 2 decades. Whereas, their bank interest rates and inflation are at 1 – 2%. Equity is always at a premium compared to fixed income products.

USA Index S&P 500 Historical Returns

Higher the risk, Higher the returns. In Fixed income products like FD, PPF and Government bonds, your capital is safe but you get fixed returns. The upside is limited. In assets like equity or gold, your capital can lose value but your upside is open.

Look at Nifty chart in the last 2 decades. Nifty crashed 50% in 2008 and 25% in 2015 but it has made up for all these losses and much more.

NIFTY 50 Historical Price Chart

If the risk is high, why should one invest in Index funds? FD and PPF do not beat inflation significantly. Equity is your best bet. PPF has a lock in period of 15 years. Index funds do not have a lock in period but one should stay invested for at least 10 years to make up for any losses during the course. And equity is better than gold and real estate because of the fact that we do not understand the price movements in the latter. In Index funds like Nifty, we know it is the best 50 companies of India. It is dynamic and keeps changing every 6 months to accommodate the top 50. Why wouldn’t you want to invest in the best companies in India which is growing at 5 – 7%?

Hence, for investors who can digest such huge fall in prices and who are willing to take such risks, Equity should form a high % of your investments. For others, allocate at least 30 to 40%. Why?

Hgher the Risk, higher the Return!

Let us look at a fixed income portfolio and an equity portfolio performance for the same duration and amount invested.

Fixed Income / Debt Portfolio – Return on Investment of 5.84%

Blended Portfolio (45% Equity and 55% Debt) – ROI of 7.43% and a surplus of 10 Lakhs

I leave it to your math skills to figure out that you can double your money and hit the 1 Cr mark in 15 years by increasing your allocation / investment in Equity.

Debt / Fixed Income Portfolio
Blended Equity Portfolio

If you understood these tables, you will realize that there are 2 levers to returns:

  1. Increase the monthly savings
  2. Increase the returns by better asset allocation (more in equity)

The rule of thumb for equity allocation = 100 – your age. If you are 30 years old, you can invest 70% of your savings in equity. Decrease the allocation as you grow old. This will give you a solid 20 years in equity which might even help you retire early.

Risk Averse – 50% FD / PPF / Liquid Funds, 30% Equity, 20% Gold

Normal – 50% Equity, 30% Gold, 20% FD / PPF / Liquid Funds

Aggressive – Can go up to 70 – 75% Equity

https://indexheads.substack.com/p/a-balanced-life-with-index-portfolio

Note – These are only my suggestions. Please assess YOUR risk taking capacity and decide accordingly. On paper, you will feel you can sit through market crash. Only when you see your portfolio in red and falling like a knife, you will experience FEAR. For Liquid Funds, I would suggest – PPFAS or Quantum, the only two liquid funds that don’t have credit risks and invest mostly in Government securities.

Tactical allocation. Equity has cycles. When the stock markets are expensive, one can move their money to liquid funds and gold. When the stock market crashes like 2008, move major part of your money to shares as you will get quality companies at cheap prices.

Here is the Excel to calculate returns and allocation. Try to optimise your portfolio by changing the returns, monthly savings and allocation. For the sake of simplicity and the fact that we do not know what returns to expect, I have ignored Gold and Real Estate.

https://drive.google.com/file/d/19zNdpGLHOH8IRzPEc9VLqPQzFEG8fUmW/view?usp=sharing

If you notice, the first 3 line items are Emergency Cash, Medical Insurance and Life Insurance (Term Plan). I will write another blog to cover these. Say NO to agents coming to you with ULIPs and other insurance related investment products. Ask them for the Internal Rate of Return (IRR) for their products. It is always below 7%. You would rather invest that money for a better return and buy a pure Term Insurance at lesser cost. Do not mix these 3 things – Tax, Insurance and Investment.

If you want a really comprehensive portfolio plan, Capitalmind has this beautiful wealth planner here –

https://plan.capitalmindwealth.com/

Do check out their sample plans as well to get an idea.

How to buy Index Funds? The same way one buys other Mutual Funds. Through brokers or the Asset Management companies directly.

Choose any out of the 4. Remember to choose direct plans. TER is total expense ratio. Fee for managing your money. This is where Index Funds have an edge over active mutual funds. (Active funds are the ones managed by a fund manager who selects stocks. Passive funds like Index funds are the ones which do not need a manager as it simply copies the Index. Google AUM and NAV).

Nifty 50 Index Funds

https://www.hdfcsec.com/stock-market/mutual-fund-scheme/hdfc-index-fund-nifty-50-plan-1080

You can buy every month for as low as Rs. 500 using a feature called SIP – Systematic Investment Plan. You can apply for SIP in their website and set automatic debits from your account to the fund on a specific date. This will bring in the discipline that is needed to continue the investment for 10 years at least.

SIP reduces the risks involved in equity by letting you buy small quantity every month and not invest a lumpsum near the market peak. Staying invested for 10 years reduces the equity risk further.

Here is a real life story of how a guy turned 1.5 Cr into 4 Cr. Read to find out his experience of disciplined investing and sitting through market crashes.

Happy SIPping the top companies in India. Sita Ma has given you a wonderful opportunity to start as the markets crashed post the Budget.

While you are at it, please ask the government to remove the capital gains tac, dividend tax and buy back tax. This will unleash the animal spirits of the market.

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Disclaimer – Mutual Funds and Index Funds investments are subject to market risk. It is your money and it is important that you understand the returns and risks of each of the asset class. Invest only if you can take the market risk. Past performance is not indicative of future returns. I am not a SEBI registered advisor.

If you have read till here, here are 2 special insights:

How to use Credit Cards? Can I save on my loan / EMI interest by using my existing investments? How? OVER DRAFT facility for both fixed income and equity products. Listen to this podcast to find out more.

Savings Account gives you a return of 3.5%. How to increase it to 6%?

Resources for individuals who want to get serious about equity investing and learn the 2 sciences, Fundamental and Technical Analysis:

https://zerodha.com/varsity/

Credits (Twitter handle & website)

@passivefool – https://indexheads.substack.com/p/lets-start-from-scratch-shall-we

@Prashanth_Krish – https://www.portfolioyoga.com/wp/

@deepakshenoy – https://www.capitalmind.in/



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Sanjay Elangovan
Figuring out what works in the markets.
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