Monday, June 13, 2016

It is important to understand the nature of investment and the risks associated before thinking of taxation

The other day I received a query from someone. This person was advised to invest his money in fixed income funds since the money was needed in around two years’ time. He wanted a second opinion.

His question was: “Should I not look at equity funds since the returns on fixed income funds would be taxable, whereas capital gains on equity funds after a holding period of one year would be exempt from long term capital gains tax. Similarly, I can also opt for dividend option, too as dividends are also tax-free.”
Here is my article published in Mid-day Gujarati today


The English translation is as under:

Should you invest in equity funds since these are more tax-efficient?
The other day I received a query from someone. This person was advised to invest his money in fixed income funds since the money was needed in around two years’ time. He wanted a second opinion.
His question was: “Should I not look at equity funds since the returns on fixed income funds would be taxable, whereas capital gains on equity funds after a holding period of one year would be exempt from long term capital gains tax. Similarly, I can also opt for dividend option, too as dividends are also tax-free.”
He quoted an oft repeated line “It is not what you make, it is how much you take home after taxes that counts”.
He was also convinced that equity funds have potential to offer higher returns that fixed income funds.
This combination of potential higher returns coupled with lower (zero, in this case) tax makes equity funds appear far superior to fixed income funds.
Both the arguments in favour of equity funds are right – potential for higher returns and that the tax-efficiency is far superior. What is missing here is the risk involved. The risk is very high that even a well managed and well diversified portfolio of equity shares may lose value periodically. Though such drops in value may be temporary, they do exist and sometime for long periods of time.
It is this risk that should be considered first before worrying about paying taxes. Many investors make this mistake of looking at the taxation first. This results in highly tax-efficient but sometimes highly risky portfolios. It is not just in case of equity, we have seen this fascination towards saving tax in many other areas of personal finance. However, we shall restrict our discussion in this article only to the question we started with.
While equity funds have the potential for providing higher returns than fixed income funds, such a statement is more likely to be true if the holding periods are long. The price fluctuations in the short term would render the fund vulnerable. One is likely to experience a highly volatile NAV in case of an equity fund as compared to a fixed income fund.
These fluctuations may result into a situation that the value of investments could be lower when one needs money. Our investor had a need for taking money out of investments in around two years.
To answer the investor above, what he was advised was the correct investment option. With a two year investment horizon, it is prudent to invest in fixed income funds. To put it another way, it would be too risky to consider investing in equity funds if the investment horizon is two years.
Consider the nature of investment first – the risk involved before you look at the taxes.if the value of the portfolio is down at the time of redemption, there would be no taxed, anyway. It is often better to pay taxes on investment income than to see a situation when the investment loses money.
Use equity funds for your long term needs and fixed income funds if the need is short term in nature.
-        Amit Trivedi
The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.



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