Avoid Getting Into The Trap Of Mis-Selling By Asking The Right Questions

India is celebrating “World Investor Week” from 23rd to 29th November 2020. This is a week-long global campaign promoted by the International Organisation of Securities Commissions (IOSCO) to raise awareness about the importance of investor education and protection. At Investica, we have always given importance to Investor Education in various ways like our blogs, Social Media posts, and the information available on the app related to Personal Finance. On the occasion of “World Investor Week”, we are writing about something that has troubled a lot of Investors across their investment journey – Mis-Selling.

Indian Investors have always invested with the help of their Bankers, Insurance Agents, or Brokers, and with all these three, there is a huge conflict of interest at play. As an Investor, it is important to identify this conflict and understand whether the advice is in your interest or the banker’s/broker’s interest. This blog will help you ask the right questions before investing in any financial product and in turn, will not make you fall prey to mis-selling.

What is the cost structure associated with the investment?

There are no free lunches in the world and similarly there are no free investments. Every financial product has some cost attached to it. While some products are very transparent when it comes to the expenses, some have a lot of hidden charges which are not disclosed clearly. Let’s look at some of the common products and their expenses:

• Mutual Funds – While investing in mutual funds, the only costs involved are Expense Ratio (Ranging from 0.10% – 2% pa) and Stamp Duty (0.005% of investment amount), Exit Load (Only if redeemed before a stipulated time frame.)
  
• ULIPs – The cost structure for ULIP varies based on whether it’s an online plan or an offline plan. However, some of the expenses are Premium Allocation Charge, Policy Administration Charge, Fund Management Charge, Mortality Charge.
  
• Endowment Plan – There is no clear cost structure for any Endowment plan in India. Due to this Endowment plans help brokers earn very high commissions and deliver very poor returns.
  
• Direct Equity – Directly investing in stocks attracts various costs like brokerage, STT, GST, Transaction charges. These charges are different for every brokerage house. With the entry of a discount brokers, the cost structure of investing in direct equity has come down drastically.
  
• FDs, PPF – These are fixed returns products offered by banks and the government of India, hence there are no separate costs involved. The interest rates get adjusted every quarter for inflation.

So, if you get approached by someone with an “attractive return” product, make sure that you ask about the cost structure of it. The costs themselves will tell you a lot about why your broker/banker wants to sell that product so aggressively. Ideally, stay away from a high-cost product as the cost eats up the return over the long term.

Is there sufficient liquidity in the investment?

A lot of mis-selling happens with products that have long lock-in periods because of a higher commission structure. As we have said time and again that having liquidity is of the essence in any investment. Longer lock-in period products have two drawbacks:

• Unavailability of money when needed and
• Having to stick to the investment even during poor performance.

Take, for example, ULIP, Endowment Plans, PMS, or AIF products. All of these have a lock-in period ranging from 3 years or more. If the return generated by these products is not satisfactory then these products do not create wealth rather you incur an opportunity cost. Opportunity cost is simply the missed opportunity of investing in a better performing product.

Hence, no matter how attractive the marketing pitch is, stay away from longer lock-in period products. And if you still want to invest, take a very small exposure of your total investments, so that you will still have some liquidity in case of any emergency.

What is the potential CAGR/XIRR of the investment?

While looking at investment returns, prefer looking at annualized returns for a one-time investment and XIRR for a periodic investment. Here’s why. So CAGR is Compounded Annualised Growth Rate. CAGR indicates how much return an investment has generated on a per annum basis. CAGR is a relevant tool to measure return for a one-time investment. However, if you have done regular investments on different dates, XIRR is a better option.

If you think about how most of the endowment plans are sold, you will realize that only absolute return is mentioned for these plans and not CAGR/XIRR. The reason being, Absolute returns inflate the number but do not show an actual representation of the return. For example, 100% absolute return in 10 years sounds very attractive, but when you convert this return to CAGR, it turns out to be only at 7.18% pa.

Therefore, looking at the right return figures before selecting a product is also very important.

High Returns at very Low Risk? Think Again

Everyone wants the best possible returns at the lowest or no risk. But it is practically impossible to achieve. Let’s take an example of Mutual funds. In Mutual Funds, there are various categories across the risk spectrum from Low to High. With every increase in risk, potential return increases. The safest mutual fund option of overnight / Liquid funds will earn you a return of 4-4.5% pa. But if someone tells you that you can generate a return of 12-15% with the lowest possible risk, then something is fishy.

All the products that are linked to capital markets, will have some risks. At best, you can diversify your portfolio to minimize the risk but complete elimination of risk is not possible. Once you understand this, you can align your expectations with the risk you are willing to take. And For this very reason, at Investica, we emphasize on Risk Profiling and have created a risk profiling questionnaire to help investors understand their risk appetite and plan investments accordingly.

What are the risks associated with the investment? What is the potential Downside?

In continuation with the above point, as you understand that there is a risk to every capital market-linked investment, it is also important to understand what are the risks associated with the investments. For example, In Equity-linked products, the investments are directly linked to stock market performance. But even in Equities, Risk can further get divided from moderate to high on whether you invest in large-cap, mid-cap, or small-cap respectively. Similarly, in Debt/ Fixed Income products, the two major risks are interest rate risk and credit risk.

While you get insight into risks, also understand the potential downside of the investments. Here’s why this is important. If an investment goes down by 10%, to give you the positive return of 10% it needs to go up by 22%. So as the potential negative return increases, the investment needs to generate a higher return to turn positive. This will help you understand whether you are psychologically ready to take the risk.

For a DIY investor, these are some of the most important questions before buying a financial product. And if this is too overwhelming for you, take help of a financial advisor who can assist you in where you should invest based on your profile and goals. You can reach out to Investica’s support team for any assistance you may need while selecting the right investment.