ज़ोर का झटका…धीरे से लगे

“What is the difference between retrospective and retroactive?” asked my broker friend Jigneshbhai, as we met over coffee last weekend after a long time.

Surprisingly, the question today was from Jigneshbhai rather than Swami.

Swami looked at my broker friend and shrugged it off. “They are the same I think. Why?”

“Well someone from the finance ministry said that the short-term tax now applicable as per this year’s budget on redemption in non-equity funds within three years is retroactive and not retrospective. And I am wondering what that means?” Jigneshbhai asserted, uncharacteristically still lost in thought.

Swami and I looked at each other wondering what that meant. We were mostly used to Jigneshbhai explaining things to us. But this time he was the one asking questions, and that too complex ones.

We gave him a puzzled look which, more or less, told him that we didn’t understand either retrospective or retroactive.

But our broker friend persisted.

“So if I sell you a product thinking its returns are going to be, more or less, tax free, and then you buy that thing thinking it is going to be, more or less, tax free, and then when it comes up for redemption, the government says it is taxable – is it retrospective or retroactive?” asked Jigneshbhai, looking up from his sheets he had with him.

As usual, Swami was the one who had to respond first.

“So what did you sell me as tax-free that I have to pay tax on now?” he asked.

“Well, I did not sell, but I advised you. I told you they were reasonably safe – like your favourite FDs but with no tax. It made sense then, didn’t it? To put money in FMPs or short-term debt funds for a bit more than a year? Now he says put it for 3 years or pay tax” retorted Jigneshbhai, almost with a tinge of bitterness that I generally associated with Swami.

Both Swami and I were a bit surprised at Jigneshbhai’s rare show of emotion in this case.

But he was not done.

“And the worst part is, debt fund holders at least have a choice of not redeeming if they can hold. FMP investors have no choice” Jigneshbhai continued, now with a tinge of anger to add to the bitterness.

“And it is not just these. You have to pay tax for any ‘within three years redemption’ on gold, international and MIP funds – all non equity oriented funds” he clarified.

We stayed silent, trying to absorb what all Jigneshbhai had said.

After a brief period of silence, my broker friend cooled down a bit. But his mood hadn’t changed much.

Swami tried to intervene. “But if I don’t sell for three years, I don’t pay tax?”

“Yes. But in FMPs, you don’t have a choice,” replied Jigneshbhai, still quite morose.

Swami almost neglected Jigneshbhai’s mood, almost like my broker friend does to Swami most of the times.

And in a state of nonchalance that I associated with my broker friend, Swami declared, “So now I got it. For FMPs, the tax is retrospective, as there is no option. For others, it is retroactive, as it relates to the past but there is an option if you hold for 3 years.”

Both Jigneshbhai and I looked at Swami, surprised at his assertion.

Perhaps he was right in the technicalities, but we were not sure. My broker friend was clearly not impressed, though he had got his definitions clarified from an unexpected source.

Grudgingly, he said, “Well, yes. Perhaps you are right. But it is still not fair. It is like changing the rules of the game after all sides have played to another set of rules.”

Just as we were having this conversation, I noticed the wealthy man from the sprawling bungalow sitting near us, listening to my broker friend’s disappointment.

He walked up to Jigneshbhai and putting his hand on my broker friend’s shoulder, he said “Yes, it is not fair. A bit like Duckworth-Lewis method forced on a match. A small rule that makes a big difference.”

As we finished our coffee, he picked up his soft drink and said, “ज़ोर का झटका…धीरे से लगे!”

Why Having Fixed Income is Important for Portfolio Goals

The best portfolio strategy for an individual investor is to start by setting a prudent desired asset allocation between risky equity assets and fixed income that the investor is comfortable with and is sustainable, and implementing it by a continuous timely re-balancing of the portfolio. This would mean selling a certain percentage of the equity part when equities have done well, and buying the equivalent fixed income part, thereby resetting the asset allocation to the desired level, and vice versa.

fixedbondsstocksOne of the requirements of implementing this strategy is to have substantial holding of the portfolio (50% to start with) in fixed income or debt funds. Unless one has that holding, it is not possible for the investor to take advantage of low market levels with timely re-balancing. One of the chief advantages of this strategy is not purely mathematical or higher returns, but psychological – related to the mental stability that the average individual investor will experience in the face of falling markets. And if he is in that state, it is likely that he will not only continue investing, but if he has the temperament and discipline, he will also shift fixed income instruments to equity at a time when market levels are low – thus enhancing long-term portfolio returns. This strategy of holding fixed income to some extent when equities are going through the roof also will give him the ammunition to do the right kind of re-balancing when equities tank, and will ensure that like other investors hurt in the crash, he will not run away from the market.

But that also means that when equities are running high, the investor has to be content (and can get a bit impatient) with lower returns due to the debt component. This will take considerable will power and temperamental maturity to stick to, even for the most disciplined individual investors – at least in the initial years of their experience.

So does fixed income play a role or is it only for fuddy-duddy’s to hold? That is a question best answered by the investor himself. But in my experience it does play a role – though that role diminishes as the equity portion of the portfolio increases specially after the investor has seen a couple of economic cycles. So the best path may be to start with an ideal, conservative allocation of 50:50 in the initial few years of investing. The investor will inevitably face the mentally tough situations of large market falls, and get tested. In such situations, the investor is likely to experience and observe his own behavior – whether he falls prey to market vagaries by selling his equity holdings, and stopping further equity investments; or whether he focuses on his asset allocation and shifts some of his debt holdings to equity to re-balance, thus taking advantage of lower market levels. Similarly, he is also likely to go through easier, seemingly feel-rich market situations when equities go through the roof, and see for himself whether he has the mental orientation to sell equities and shift to debt, or ends up going with the crowd increasing his equity exposure.

After having gone through a few such situations in the initial few years, the role that debt funds play in an individual investor’s portfolio is likely to be self-evident. In case he is actually investing regularly with increasing income levels with time, and has gone through a couple of market cycles, it may then be prudent for such an investor to progressively reduce the percentage allocation to debt. Simply because he is confident that he can handle market volatility easily, and secondly because, his portfolio is likely to have reached a size where the effects of re-balancing will likely give diminishing returns.

So yes – debt funds or other fixed income instruments do play a definite role throughout an individual investor’s lifetime. It plays a larger role in the initial years when the effect of asset allocation and re-balancing need to be proven and seen by the investor himself. Unless an investor has fixed income investments, it is not possible to take advantage of market falls by making tactical shifts to equity – thus losing out on long-term portfolio returns. Beyond the first few years, fixed income will still play a similar role where it acts as an income earning store of booked past profits, as well as a pool to access when lower market levels warrant a shift to equity. But the investor can potentially afford to be a bit more confident of his ability to handle market volatility at that stage, and progressively reduce the allocation to fixed income to enhance returns – while still maintaining the percentage of fixed income assets to a significant level. It may be prudent to start with 50:50 allocation initially, and over years and experience of making regular investments, and implementing the asset allocation and re-balancing strategy, progressively reduce the fixed income allocation – but perhaps, never dropping it below 25%. As market vagaries will still continue, and he will still need a store to take advantage of it – and in larger quantities to make an impact as his portfolio size increases.

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