Don't let numbers fool you: Learn ways to evaluate financial instruments

In the complex world of finance, numbers can be deceiving. A good salesperson can sell a poor investment product as the best available in the market. He doesn’t even need to tell a lie. Staying within the norms the regulators have prescribed, he can mis-sell a product showing correct figures. After all, 7.5 per cent annualised returns over a decade also mean 100 per cent returns on the principal amount. A 12 per cent loan can turn out to be a 21.2 per cent one if a borrower doesn’t understand the difference between flat rate and reducing balance rate.

Investors and borrowers, who are smart and cautious, usually spend time understanding terms and conditions when evaluating a product. They tally the information provided by an executive or agent with the product documents. “Many think that mis-selling is when executives or agents lie about certain features, avoid mentioning conditions or give false promises. That’s not entirely correct. They also need to be wary of the number game,” says Suresh Sadagopan, founder, Ladder7 Financial Advisories.

Being aware of a few basic investment principles and financial concepts can help you evaluate a product easily and take a call regarding whether you should opt for it.

Time value of money: Recently, an insurance agent approached 45-year old Raj Prakash Singh with a promise that the product offers lifelong 10 per cent return on investment. No annuity plan for life gives this kind of return. At present, the returns are around 4.5-6 per cent. The agent explained: If Singh invests Rs 1 million now, he will start getting around Rs 100,000 a year after 10 years.

While the returns are indeed 10 per cent on the investment amount, what the agent didn’t share is that for 10 years there will be no payout while the money will earn interest and grow. At 7.5 per cent interest, the money can double in a decade. If the insurer pays Rs 100,000 annuity on a corpus of  Rs 2 million, that’s just five per cent annual return. “If the amount is invested in equities for such a long period, the returns can even be higher. On retirement, the money can be invested in an instrument that can earn better post-tax returns,” says Malhar Majumder, a certified financial planner.

Fund performance can be deceiving: This is the oldest trick in the trade to sell a mutual fund or insurance product. When certain mutual funds start doing well, the agents begin showing one-year returns to market them. In the current market, a few diversified equity schemes have given over 20 per cent returns in the past one year, which are much higher than the rest of the category. But when you look at the historical returns, a clearer 
picture emerges.

If you look at the 10-year period, a few of the diversified equity funds delivering over 20 per cent returns have underperformed the category as well as their benchmark. Historical returns are one way to look at performance, but rolling returns are the best way to evaluate a fund’s performance. It means, an investor should look at returns over different periods rather than just point-to-point returns – it can be from February 2017 to February 2018, January 2017 to January 2018, and so on.

Deepesh Raghaw, a Sebi-registered investment adviser, points out that many invest in unit-linked insurance plans based on returns. But what those investors don’t realise is that the money that goes into the investment amount is after deduction of various charges. If a 30-year-old and 50-year-old both invest the same amount, the latter will have much lower returns as the mortality charges will be higher for an older investor.

Returns can be manipulated: In traditional insurance plans, the agent lures investors with bonuses, which are the return on investment. The pitch goes like this: If you invest Rs 50,000 every year, the insurance company will give a bonus of Rs 40,000. That’s 80 per cent extra on your investment. But the bonus is given at the end of the policy tenure. If you combine the two (50,000 + 40,000) and multiply with the number of years (20), you will end up with a corpus of Rs 1.8 million. That’s around 5.4 per cent annualised returns on investment.

Sadagopan points out that many companies show simple interest rate as the return from their fixed deposit (FD), which is misleading. If the FD is giving 8 per cent interest, in five years  Rs 100 would grow to  Rs 146.93. The return in a five-year period is 46.9 per cent. Some companies simply divide this by five and say the “effective” return that they offer is 9.38 per cent.

Arnav Pandya, a certified financial planner, says that many times in tax-saving products the tax deduction is added to the returns, bloating them when the actual benefit might be less. Usually, for such calculations, product manufacturers or agents show the benefit an individual in the 30 per cent tax bracket can get.

Untangling complex calculations: If you don’t understand a product, it’s best to stay away from it. Financial planners give an example of mis-selling of bonds. In a low-interest rate, many investors chase bonds that have a high coupon rate. But they don’t realise how to calculate the correct bond price. They are sold bonds based on the coupon rate, and they pay a higher price than the face value, which reduces the yields. Lovaii Navlakhi, MD and CEO of International Money Matters, points out that similar complexities exist in the returns calculations of Nifty and Sensex-linked structures that are popular among the wealthy.