How to invest in gold the right way

gold-coinIndians have an unexplainable love for gold. We can never have enough of gold. That is the reason jewellers go and announces various “auspicious day(s)” for buying gold. We also think that buying gold is a valid form of investment.

People always say that gold prices doesn’t always decrease (which isn’t exactly true if you look at historical prices). But Gold is an important asset class and everyone should have part of their investment made in gold.

Gold acts as a nice hedge against inflation as it increases along with inflation (mostly). So lets see what are the various forms one can buy gold in India.

Ornamental Gold

The truth is ornamental gold is never an investment. Because while we buy a gold jewellery, there are numerous extra charges which we have to pay for like making charges, wastage, etc. Sometimes, these all add up to even 30% more than the cost of the gold.

And when you go to the same shop to sell your jewels, they just give you money for the percentage of gold you have in the jewel. Thats right, all the making charges, wastage you paid is all your expenses and you don’t get it back.

Apart from that, most shops would want you to buy back some new jewels from them instead of giving you the cash. They would attract you with new designs and models and you would end up paying even more money from your pockets to get the new jewels.

Ornamental gold has an emotional value attached to it. People buy it for weddings or special occasions and wouldn’t want to sell it. The most that they can do is get loan by keeping the jewels as collateral and you would be paying extra money as interest. It isn’t that easy to convert gold jewels into money in an instant.

Gold Bars and coins

So how about buying gold as bars and coins. Most shops and banks/post offices sell 24 carat gold coins and bars starting right from 1 gram. They have a purity certificate and since it is in the form of bar/coins, they don’t have making charges/wastage. And they also assure you that, while selling back you would get the exact gold rate on that particular date.

So does that mean you can go ahead and buy it and store it in your safe and sell it when you need money? Not that easy. No bank or post office would buy back gold coins which they sold to you (even if it were just a few hours back). They just sell gold to you and their transaction is done. For selling, you would have to go to some gold shops and sell to them.

And what would these gold shops do? Right, ask you buy jewels from them instead of paying you by cash. Is there no way to get back money you “invested” in gold coins? You can, but you won’t get back that day’s gold rate. You would get only a discounted rate and so you are making a loss.

How else to “invest” in gold?

Now you are fed up and asking “How the hell am I supposed to invest in gold?”. There are two ways you can really invest in gold and get back money whenever you want to. Enter the world of Gold ETFs and E-Gold.

Gold ETF

ETF stands for Exchange Traded Funds which is a fancy way to saying “you give money to someone to help manage some security”. In the case of Gold ETFs, you pay money and buy N units (1 gram) of Gold. It is bought and sold like shares of a company in the stock market (NSE). Its all stored electronically in a special account of yours, called DeMat (Dematerialized) Account.

You pay the fund a small fees to manage your gold (though there isn’t much managing to be done). There is no problem of security, as all your gold stays in your account and cannot be opened/stolen by anyone else. The price of the gold ETF would track the price of a one gram 24 carat gold in the market.

There are many companies which sells Gold Fund and you can practically buy any one of them and you would have invested in gold. I would suggest the Gold BeES, because it is easy and can be bought directly from the NSE.

E-Gold

Then what is E-Gold? E-Gold is also an electronic way to buy and sell gold. Only difference is you would be buying Gold directly from the National Spot Exchange. You pay for whatever the price of 24 carat Gold was at the precise moment. No need for any fees to be paid to some fund house.

It is a good method of investing if you want to buy physical gold at a later stage. You can use the gold accumulated in your DeMat Account and buy jewels from the shop, without having to risk storing/safe guarding the gold in your safe.

Which form to buy?

For investing your money, always choose Gold ETFs or E-Gold. It doesn’t make a difference to both if you intend to stay invested in the long run. Both these are very liquid – meaning, if you suddenly want money you can tell your broker to sell X units of your gold and you would get back money immediately, without losing anything on wastage/impurity/etc.

But if you are buying gold for some wedding or as a gift to your wife so that she can wear gold to a function, you have no other option than to go and buy the gold jewels. But do remember that this money you spent to buy gold is an “expense” and not an “investment”.

Remember the difference between these and you would make sure you don’t “spend” more on gold and instead “invest” in it. Remember it is not advisable to invest all your money into gold too. There is the equity market where you would get much better returns if you are willing to stick around for the long term.

Why you need to diversify your portfolio

Yesterday we saw the various options where you can invest your money (and also save tax). But you should make sure you shouldn’t put all your money in a single place. The risks are either you wouldn’t earn enough returns on it or you may lose all your money. That is the relationship between risk and reward.

More risk = More reward.
Low risk = Low reward.

The best solution to this, is to split your investment into various asset classes, so that you minimize risk and also get better reward.

Let me show you some examples of why putting all your money in one asset class is bad.

Investment Cycle

For quite a few years, everyone were investing in Gold, thinking it would always increase in value. But this year, after reaching new highs it began to drop quickly. Everyone who invested when the value of gold was reaching new highs, are now at a loss. And it would take many years for them to get profits.

This doesn’t apply just to Gold. There were many who invested in the equity market because the market was reaching new highs in 2008. But those put in all their money then, still are yet to recover and would take a few more years to become profitable.

So did people who had all their money in fixed deposit in 2003-2004, they didn’t participate in the bull run of the equity market. Their returns would have been very low than those who invested in shares.

What does this teach us? Every asset class follows a cycle. When one particular asset class is bullish, others wouldn’t be giving you any returns and sometimes would even be negative.

The best way to protect against this is to invest in all types of asset classes. But now is the question of how much to put in each class.

What percentage, in what?

It isn’t easy to say how much one should put in equity vs debt vs gold vs real estate without understanding your financial profile and risk appetite. But there is a simple rule of thumb that should work out, especially to find out how much one can invest in equity.

Take your age and subtract it from 100. That is the percentage of your investment that can be in equity. So if you are 25 years old, you can have 75% of your investment in equity market. “But, but, you said Equity was risky. I don’t want risk”. Yes. equity is risky, but if you keep invested in the long term, you minimize all risks.

Since you are just 25, you still have a long way to go and can thus put in more money a risky investment. The remaining 25% can be split into fixed deposits, gold, etc. By investing a majority in shares you would get a better return than just fixed deposits. When you grow older, you should slowly shift your investments from equity to debt which is more safer (but also rewards less).

TL;DR: Don’t put all your eggs in one basket. Split your money into different asset classes. Younger you are, the more risk you can take.

What is section 80C of Income Tax

Many employees would have heard from their HR or finance department asking to give details about investments made under 80C. So what is this 80C? Let me explain with an example.

Lets say you earn Rs. 5 lakhs salary per year. For upto Rs. 2 lakh, you don’t have to any tax. That means, you would have to pay 10% of the amount which exceeds Rs. 2 lakhs, i.e., 10% of 3,00,000 = Rs. 30,000. You have to pay Rs. 30,000 as the income tax for the financial year.

Now lets assume you invested some money (Rs. 1,00,000 which is the max) which come under the section 80C of Income Tax Act, this entire money is now tax deducted. Meaning, you will have to pay the 10% of just Rs. 2 lakh = Rs. 20,000. You save Rs.10,000 on your tax bill. You already invested Rs. 1 lakh in some investment product + you also save an extra Rs. 10,000 (which would have gone to the government). How cool is that?

Investment Options under 80C

Now you may ask what are the options one has to invest under 80C. Here is a list.

PF/EPF – Employee Provident Fund: Employers (having more than 20 employees) should deduct a percentage of your salary and deposit in your name in a EPF account. This deduction is counted against 80C and you can use the same account even if you switch companies. All the money they put in here will grow and be useful when you retire in the far future. The best part is the interest you earn is also tax free.

PPF – Public Provident Fund: Any person can open a PPF account in SBI or ICICI bank or post office and deposit money in it every year. It is useful if you work for yourself or you work for a very small company. It must be maintained for a minimum of 15 years and can be extended by 5 years after it matures. Minimum contribution is Rs. 500 and Maximum contribution is Rs. 1 lakh per year. And it earns 8.7% which is also tax free like EPF.

NSC – National Savings Certificate: You can purchase National Savings Certificate from any post office or online in some banks. Period of NSC is either 5 or 10 years and it earns an interest rate of 8.5% as of today.

But remember, the interest you earn through this is considered an income and will be taxed separately every year. You can however choose to reinvest it again.

5 year Bank Fixed Deposit: Banks have a fixed deposit which can be used for tax saving purpose which has a term of 5 years. It would earn somewhere around 8.5-9.5% depending on the bank. The money you put in will be locked in for 5 years and can’t be prematurely withdrawn. The interest earned is taxable.

5 year Post office Time Deposit: Just like banks, post offices too have fixed deposits called Time Deposit. The 5 year term plan has tax savings benefit and earn 8.4% interest. The interest is taxable.

National Housing Bank Suvriddhi: NHB also has term deposits for 5 years which has tax benefits. It earns 9.25% interest rate and has a minimum deposit of Rs. 10,000 or multiple of it.

Life Insurance Premium: Any premium you pay for life insurance can be claimed under 80C for tax saving purpose. This is the main reason people take endowment policies which has huge premiums and very little cover. But after April 1, 2013, only premium equal to 10% of sum assured will be allowed under 80C. So you can’t pay Rs.50,000 premium for just Rs. 1 lakh insurance cover.

My suggestion as mentioned in a post before is to take a term insurance and invest the remaining money in the other options which earn a better return.

ULIP – Unit Linked Insurance Plan: This is another life insurance product, but your money would be primarily invested in the equity market. So if the equity market performs well, you would get better returns. If not, you money can be lost. It is not advisable to invest in ULIPs as you should never mix investment and insurance.

Pension Fund: There are a few pension funds (LIC or other private insurers) which can give tax relief for the financial year. This comes under the section 80CCC, which is part of the 80C when it comes to the calculation of the Rs. 1 lakh limit.

NPS – National Pension Scheme: Money invested in NPS in Tier 1 scheme is deductible from Income Tax under the 80CCD section. But the aggregate deduction from 80C, 80CCC and 80CCD can’t exceed Rs. 1 lakh. So if you have already invested in other products, there isn’t much you can do here.

ELSS – Equity Linked Savings Scheme: This is a mutual fund schemes which has a lock-in period of 3 years (the lowest lock-in period) that is approved for tax savings. Your money invested in ELSS funds are invested in the equity market and you would get better returns if the market performs well. It is risky, but if invested properly and in the long run it can earn better returns.

Another good news is any dividend you earn is tax free and also if the market doubles or triples your investment in 3-5 years and you take all your money out, you don’t have to pay even a single Rupee as tax. Any equity invested for more than 1 year comes under long term capital gains which has no tax.

Tuition Fees: If you have kids going to school or college, the tuition fees paid for their education is tax deductible.

Home loan Principal Repayment: If you take a home loan, you can claim the principal paid every month for tax deduction under 80C. Do note that only the principal can be claimed under 80C and during the initial years of the loan repayment, you would be paying most of the interest. Only during the later stages you would be paying more of principal and less of interest.

Stamp Duty & Registration Charges for Home: If you bought a house, you would have paid stamp duty and registration charges. You can claim this under 80C if you bought it in that financial year.

Why save tax?

You might be wondering why I am asking you to save tax rather than investing in high yielding products and becoming a millionaire. Money can’t grow suddenly, it grows slowly and exponentially if done the right way. But before that, we need to make sure that we make sure that we reduce our tax bill as much as possible.

Section 80C has excellent investment opportunities which also helps you save tax. This extra Rs. 10,000 you save on taxes every year can be invested properly and earn you a nice extra money when you retire. Or you may choose to use that money to go for a trip. It depends on you. But remember, any money you can save is money you earn.

Which option to choose?

Now you might think which of the following options are better? Remember, there are a few products in there which are risky like ELSS and ULIP and others which are very safe like PPF, bank deposits, etc. Also remember the returns you can earn is directly proportional to the risks you take.

The first investment you should make is buying a term insurance. Lets say the premium is Rs. 10,000 for a sum assured of Rs. 1 Crore. The remaining Rs. 90,000 should now be invested in partially in risk free products and partially in risky products. So that overall the risk is mitigates and your returns are higher than sticking to a risk free product.

Lets take an example: Your company deposits Rs. 20,000 as EPF and you have a term insurance with premium of Rs. 10,000. You have Rs. 70,000 to invest. You can now invest about Rs. 40,000 in ELSS, buy a 5 year term deposit for Rs. 10,000, if you have a kid you can claim the tuition fees and also claim the loan repayment for your new apartment. Overall if you add all your investments make sure you reach the goal of maximum Rs. 1,00,000 so that you gain the maximum benefit.

Now you may be wondering how splitting the money into different products help you. Its called portfolio diversification and lets see that in tomorrow’s post.

P.S.: Want to know why the government provides tax relief for these investments? Because these investments help growing the economy of the nation in some way or the other. Be it investing in the equity market (long term) or education of your children or building news houses – they all contribute in some way to the making the nation better. So the government gives tax benefits for these investment.

P.P.S: Also don’t think of these as evading tax. You are actually saving tax and in the most legal way. Also helping to make your country better. You getting more money out of your investment is an added benefit.

What are the various Asset Classes?

To invest your money somewhere, you need to know what are the various options available. Money that you have is your asset and you need to put your money in different places so that they grow. These products where you put your money are grouped into various asset classes.

Each asset class has its own risks and returns. But you also need to take into account how liquid your asset is. If you need money immediately tomorrow, how easily and quickly you can take the money out. Lets now look at the various asset classes:

Cash

This is the most easiest to maintain. You just have all your money as cash with you in your house. This is the risk free, except for safety against burglars and inflation. We already saw in yesterday’s post about why its a bad idea to store your money under the mattress as you don’t earn any interest on the money you have in hand and it’s value also  erodes slowly due to inflation.

Savings account

You can have some money for your daily expenses and emergencies, but a better option is to have it in at least a savings account. Savings accounts in India gives a return on about 4-7% depending upon the bank and the amount you have. It is as liquid as having cash in your hand as you can withdraw anytime using the ATM card. It also earn some extra money as it lies sitting idle.

Debt

Debt is a better option than savings account as it can earn you a higher interest rate. When you lend money to someone (a bank or other institutions) they will have to pay you something extra for the money you give. There are various forms of debt like Fixed deposits, bonds, NCD (Non-Convertible Debt), etc.

Fixed Deposits

This is the most common way people keep their money in banks. This is also safer as the bank takes care of lending money and collecting it from the borrowers. Also your investments in banks are insured upto Rs. 1 lakh.

Usually FDs earn anywhere from 7% – 10%, but it depends on the term you are investing it for. Usually the rates are a bit higher for senior citizens but it doesn’t matter to us right now. And do remember the rates also depend on the banks. There are some banks which don’t give more than 8.5-9% and there are some which give 10% or more.

About liquidity, you would be charged a slight penalty on the interest earned if you try to take out the money before your term finishes. But your invested amount won’t be affected in anyway.

Bonds and NCD

Bonds and NCDs are money that you lend to the government or companies. Government and some companies issue bonds which has ask for money from the public. This money would earn a slightly higher interest rate than fixed deposits. But remember as your returns increase your risks also increase. Usually you would earn anywhere between 10% – 12%.

Before you invest in bonds, you need to check for the quality of the company. If it is a bond issued by the government it is considered safe (especially if you have a developed or a growing economy and don’t have problems with the government). But as part of general public it is difficult to understand how good or bad a company is. So there are credit rating companies which rate these bonds during issue. This gives a good enough score about the company.

Generally bonds are preferred by people who need to know how much money they will earn and need a guarantee that they will get back the money. Amongst the public, there are only two kinds of people who fall in this category – old people who want to put in their retirement money or very rich people who want to earn an assured income from their money.

Gold and Silver

There are many people in India who like to invest in precious metals, especially Gold. The reason they prefer gold as an investment is the price of gold never decreases. But this is not true. History has shown that the price of gold doesn’t always increase. But Indians in general have very poor memory when it comes to gold as we have unreasonable love for the yellow metal.

But Gold should also be a part of your portfolio, because it is a good hedge against inflation. Meaning, the price of gold rises with inflation in the long run. It can’t beat inflation, but it rises along with inflation.

But investing in gold needs isn’t just buying a gold jewellery from your nearby shop. There are various efficient ways to invest in gold, which we will see sometime in the future posts. The safety of gold is dependant on how you invest and store it. Buying jewels and having them in your safe is not safe (pun not intended) and also it isn’t liquid enough.

There are however Gold ETFs and E-Gold which can be a valid investment and also safe and liquid enough.

Real Estate

Real Estate is a hugely popular form of investment, especially for urban Indians. Everyone would like to have their dream home. They usually take a home loan and buy an apartment. It is a good idea to buy a home even if it means taking a loan, but if you already have a own house to live in, it isn’t advisable to invest in another house.

People in India also have a unexplained liking for real estate, saying the prices of land can never go down. But historical prices has shown that they don’t rise with inflation as much as you would like it to and not every land you buy appreciates. If you bought a piece of land and a nuclear power station comes up nearby, your land value would decrease.

It is important to research well before investing in real estate, as it is immovable property and very hard to liquidate. Also people are invested both financially and emotionally into a house or land and wouldn’t easily sell it off.

Equity

Equity is also popularly called the Share Market or Stock Market. Lot of people don’t like to invest in equity markets as they would have lost huge amount of money once and some even compare it to gambling.

But equity is the only investment that can beat inflation, when invested over a long period. There are two kinds of people in the equity market: Traders and Investors. Traders put in money to buy shares of a company and sell it in a very short time frame, like in hours, days, weeks. They buy shares and sell it (or sell it first and buy it back) when they have earned a small profit. If they lose money they exit the trade and take in the loss.

The people who stay away from equity because they lost their money always come into the equity market to make a quick buck or two and when they encounter a loss immediately hate the market. Traders are doing a business, meaning they accept both profit and loss when it comes.

But we are investors, who want to make sure that we don’t lose our hard earned money. Equity markets are risky (riskiest of all the ones I mentioned above), but when invested smartly we can make sure that we don’t lose our money. But the first rule you should remember is to be in the equity market for the long run. Its not “invest now and earn double in a year” thing. If you buy shares of a company and within a year your money could potentially be wiped out entirely because of various reasons. That is the risk you have in equity, where your entire investment is gone.

When you invest in it for the looooong term, the risks are minimized and you end up with a nice profit which can be anywhere from a few extra lakhs to even multiple of crores (depending upon where you invest).

So where should you put all your money in?

It is very hard to give a single, unified answer to this question. It depends on various factors like your age, your salary and expenses, your risk profile, your retirement age, etc. Once you understand these various asset classes, I can help you to create a portfolio that is practically risk free and also earns a good return than most of your friends.

Why you shouldn’t store your money under the mattress?

If you had asked this question sometime in your life, don’t worry – it isn’t a stupid question. In fact it can be used to easily explain one complex term “Inflation”.

money-under-mattress

Lets assume you and your friend got into a job and get the same salary (say Rs. 25000 per month) and you both coincidentally have the same expenses (just for calculation) and both have a surplus of Rs. 10,000 per month. Just for easier calculation, I am assuming you both can only get a surplus of Rs. 10,000 per month even though you might have got numerous pay raises and there are no emergencies in the family.

Lets compare both your situation based on what you do with this surplus money. Your friend (lets call him “Dumb Dinesh”) doesn’t trust banks or other financial institutions and decides to withdraw all the money and store it under his mattress. Can be taken literally or also figuratively where he keeps all his money in a safe in his house. What are the risks?

Immediate risks: it (the entire safe) could be stolen by robbers when he is on a vacation, his house could catch a fire (or flood) and everything is destroyed, etc. These are easy to imagine, but there is another form of risk that you can’t see the effects immediately. That is inflation.

Inflation is the general rise in prices of goods and services in an economy over a period of time.

To explain it easily, lets say a dinner for two in a nice restaurant costs Rs. 1000 today. 10 years in the future the same dinner in the same restaurant would cost Rs. 2000. Which means the cost of the product/service has increased by 2 times over 10 years.

Now imagine “Dumb Dinesh” keeps all his money Rs. 10000 per month for 30 years he is in a job in the safe (assuming it isn’t stolen or caught in a fire) he would have a total of Rs. 36 lakh. With Rs.36 lakhs say one could buy a nice premium car (Audi? Benz?) today. But 30 years later, with the same Rs. 36 lakhs, he could only be able to buy a Hyundai Santro.

That is what inflation does, it erodes the value of your money slowly and at the end of 30-40 years, when you got no source of income, it becomes very difficult to lead the same comfortable life you live today with the same money.

Lets now take your case, where you our reader, understanding how inflation works, decided to invest your money smartly and safely. Even if you invested Rs.36 lakh as a lump sum amount today in a very modest interest rate of 8%, and doing a simple interest calculation for 30 years would yield Rs. 86.4 lakhs. That is more than twice of what you invested.

But remember, money always grows exponentially because of the effects of compounding as we have seen earlier. Also investing regularly and compounding the returns, you can get returns in terms of crores. Compare the few lakhs “Dumb Dinesh” vs your investment which has grown to crores.

Easiest way to beat inflation is to make sure you invest your money in products which yield higher rates than the annual inflation rate. The government regularly publishes the inflation rates as it fluctuates over a period of time. Eg: if the average inflation is around 6-7%, then if you invested in products earning anything more than 8%, you are safe and your investment is protected against inflation.

Also remember, you don’t withdraw your entire money in your portfolio on the day you retire. You take it out monthly, to meet your expenses. And while you have taken out a few lakhs for your monthly expenses, the remaining crores of rupees are sitting safely in the bank/investment products still earning you more money.

In the end you turn out to be a winner by a HUGE margin than your friend who stored his money under the mattress. Tomorrow we will look at the various types of investments that are easily available to Indians and their rates of returns.