Financial Wisdom By Kalidas

Ref: 0908-031A of 21-08-2009

In the days of Kings, Queens, Sultans, Moguls and Rajahs, there were only two currency denominator with reference to which a person’s wealth was measured. – Gold and Silver. Other units used were the number of sheep’s, goats, horses, cows and buffaloes.

However, these objects were relatively scarce, and hindrance to trade development. When paper was invented, especially Security paper, the concept of bank notes was introduced. It revolutionized the coming century. A time came when Alan Greenspan was spoken of more than the Jesus Christ.

Having seen the investment medium of Gold (Silver and Palladium will be discussed later), let us see how a person should build wealth that is liquid, earning and transferable. East and West followed different philosophy, thanks to many Nobel Laureate Economists who invented number of theories understood either by them only or some small fraction of so called professionals who brought the financial ruin as you witness today.

WEST followed the policy of “Spend first, Save later” and used plastic money (credit or debit cards) with gay abandon. Paper and Plastic were the two numerators of proof of wealth. When I went to USA a few years ago, I tried to pay them with greenback, that is, $ 100 green dollar bills so much loved by the Asians over here.  They love dollar more than their wives and children. The counter clerk asked me “Sir, don’t you have credit card?  We can not accept this note” I asked him for reasons to which he replied, we do not know whether it is genuine or fake. WOW, we Asians go mad after dollars, and these Americans do not trust their own currency!

EAST followed the policy of “Save first, Spend later”, diametrically opposite of western philosophy. This is why Asians prospered, and West was brought down to knees. After contracting debt via credit card, if the consumer can not pay, the remedy was easy – go bankrupt!

Look at the following table, how much consumers gain or lose in following West and East policy.

We compare two countries – USA and INDIA for simplicity.

Let us say, an American bought a few items for US$ 10,000 via Credit Card, paying interest @ 12% on average (it varies between 7% earlier to 16% to 24% now) for say, 3 years. An Indian saved the money for 3 years earning 9% interest and then decided to spend it. The cost of the items is worked out as under:

MORALE:

1. If Debt via credit card is used for consumer item, it is irrecoverable expense. The item also depreciates over 3 years, so that realizable value also diminishes.
2. If no debt is used for consumer items, but savings resources were used instead, the cost of the item is reduced by interest income on savings.
3. Debt is useful for a businessman because he employs the amount for earning. Though he pays interest, he also earns income or profits. His loss or gain is the difference between the two. It is“two way traffic” for him.
4. For an employee, having no other income than salary, he loses on contracting debt, because no income is created out of debt. It is a “One way street” for him – loss only.

This is why the East is asserting on West now. America is technically bankrupt with years of consumer spending financed by Credit cards. Eastern countries like China, India and other Asian nations have acquired wealth due to their reliance on savings rather than debt.

Make your First Million by Savings (very difficult), Subsequent millions are easy.

Making first million in any currency anywhere in the world is extremely difficult. One makes or loses continuously, learning all the time. The balance so accumulates make the million after long time, may be 3 to 8 years.

Once one has made real one million in the currency of his country, he has sufficiently learnt the art of making a million. If he is able to hold on that million for at least 3 months, making of further millions become relatively easy process. There is a saying that “Money attracts More Money”. It works both ways – once one begins to lose, the lost money attracts more money from the holder, compounding the losses. Similarly, when one has made a million, the chances are the money that he holds will attract more money inward to make him rich.

So let us make our first million in the currency of your country. A million is a million, regardless of any currency. The PPP or Purchasing Power Parity operates silently in every currency to make the above idiom true.

Bank Deposits vs. Bonds;  Currency Risks, Capital Risk and Exchange Risk

Each country has its own products for savings. For instance, it is easy to buy Treasury bonds in USA, howsoever small amount may be. In a country like India or Hong Kong, the availability of Treasury bond is limited to large amount, often 250,000 minimum. An ordinary saver can not handle such amount. He is not millionaire yet. Now again, I remind you of the difference between “Savings” and “Investment”.

• When one makes a deposit in the currency of his country with assurance to return the same currency in same principal amount (plus interest), it is called “Savings”. Example, one takes out bank deposits for say 100,000 in currency “X” with interest @ n%, with assurance to return the money on maturity in same currency with interest, it is Savings. (He gets X100,000 + n% interest)
• Where one makes deposit in the currency of his or other country if his local currency is convertible), with no assurance that same amount will be returned to him later on maturity, it is called “pseudo Savings cum Investment”.
  • He is assured here the same amount of foreign currency on maturity + Interest, but he is not assured the same amount in his local currency. He takes exchange risk that may give him increased or reduced return. This is the first level of risk he undertakes.
• If one buys the Treasury Bond, in his currency or foreign currency, he takes on one more risk – the interest rate risk. If the interest rates go higher/lower, the capital value of the bond reduces/increases during transit time (until it matures). On maturity, he gets the same capital value in respective currency.
• If one buys corporate, municipal bond or state government bond, then he takes one more risk – the credit risk of respective corporation, municipality and state government.
  • For instance, in USA, many of the Municipalities or state governments face severe liquidity strains or nearly bankrupt.
    • The federal government in USA is not kind enough to guarantee the bonds of state government or municipalities (FED would stupidly guarantee $306 billions of Citibank bonds, but not even $ 25 billions of the State of California)
    • A country like India is more responsible. The Central government always comes to the rescue of the state governments or local semi government authorities

Having seen the difference between Savings and Investment, let us dwell on the specific products and their variations.

BEFORE that, please note that if you do not understand any investment products, simply say NO. In investment world, there are many conmen or crooks that are out to reach your pockets with innovating scheme or theme. They get paid liberal commission by the issuers. You must therefore be prepared to say firm NO. These two letters will save your life’s savings.

Also, when you are talking of the savings, do not include “investment” or “credit risk” profile. Savings must be Savings – totally risk free – returnable to you intact on maturity with interest on maturity. Here are some principles of how to save in bank deposits:

Fixed Deposits: (with Banks)

In centers like USA, Japan, Hong Kong and other dollar block countries, the interest rates are near zero. It would be stupid to invest in such deposits on long term basis. Use the following guide:

If interest rates are very low, follow the table as under:

Remarks :

• Do not lock up your money for long, if the rates are not so favorable
• Until rates rich 9%, do not lock up for longer period. Eat interest every quarter.
• By rule of thumb if the interest is over 10%, one may lock in yield for 12 months to 36 months. Make it cumulative, so that you earn interest on interest. That is, your effective interest rate is 11% (10% regular + 1% (10% of 10%) = 11%)
• DO NOT make single large deposit. Make 3 to 5 units minimum. The reason is if  you need the money for any emergency, you can break the deposit (withdraw before maturity, paying some penalty).
• If you are making deposits for 3 years or more, do as under to maintain continuous cash flow. Say you have X 500,000 to keep as bank deposits, keep 100,000 each maturing on expiry of 36 months, 38 months, 40 months, 42 months and 44 months.
  • This will ensure that after the expiry of 3 years, you have cash flow of 100,000 every two months.
  • Further, if you need some amount earlier, you need to break or withdraw premature only one unit without disturbing others.
• CHECK the maturity value before leaving the counter. Most people presume that banks are always correct. It is not so. The clerk who is servicing you may make clerical error and write wrong amount.
• USE the following Interest calculator – one of the best tools around. It is free software which works out interest and cumulative amount on loans, deposits, recurring deposits etc.
  • It has small limitation. It uses 360 days per year which is international standard for Bond market, not Fixed Income market like Deposits where they use 365 days per year as standard. (In India and Hong Kong, for instance)
  • This tool is very useful in planning your savings. Fixed, Savings, Recurring Deposit (very powerful concept discussed later)

While opening Fixed Deposit account, please ensure that –

1. You are opening jointly with some member of your immediate family, say spouse, if your own age is 55 or more. Make it “Either or Survivor” (E or S) if you trust your named partner.
2. In some countries like India, nomination facility is available where you can nominate non-depositor but your immediate family members like son or daughter, should anything happen to you or your spouse. This will avoid all legal formalities like will, probate, letter of administration etc.
3. One may avoid nomination by including one more name after his name, say of Son or Daughter, but limiting operation in account as “Former or Survivor” which means that one will get the payment on maturity, not other beneficiaries. Former means you. If one makes a mistake in writing his Children’s name ahead of his own, then they will get the money on maturity, not he. Other beneficiaries will get if only original depositor dies.
4. If you are 55 years or older, NEVER EVER give away your entire wealth to your children,. They will take care of you only when they know that money will be theirs when you are no longer around. Otherwise, you may have to wash dishes in their homes and reduce your status to that of a house servant or even worse. Money always talks, remember that always.
5. In liberal countries like USA, where marriages often do not last long enough, it will be advisable to keep deposit in your own name without the knowledge of spouse. Such confidentiality will avoid substantial payment or alimony in divorce proceedings.

1. Many frauds have been reported in India, when a Non Resident Indian (known as NRI) remits large amount without taking adequate precaution.  Note the following example (Illustrative)
   1. A NRI remitted US$ 100,000 by wire or TT to a small town branch of a nationalized bank with request to open the Cumulative Fixed Deposit (CFD) for 3 years in favor of the depositor and his wife. Since the online account opening facility was not available, he requested the Branch to send him the “Account opening form” for his signature and documentation. This was perfectly normal.
   2. The Branch Manager was not honest. He sent the FD Acct. form to the depositor with specimen signature card. At the same time, he issued the FD in the name of same depositors and attached the signature card with fictitious signature.
   3. On very next day, he created a loan in favor of third party and pledged the FD duly discharged by him and also signing necessary loan documentation forms.
   4. Meanwhile, the depositor sent him the Account form. The Branch Manager sent him another FD with similar particulars. Since the FD was for 3 years, and interest being cumulative, he did not know of this fraud for 3 years until his FD came for maturity and he wanted to cash it out.
   5. The Branch Manager was changed. He informed the depositor that third party had defaulted on loan, so the deposit was adjusted against the loan. No further amount was payable.
   6. The depositor then complained to his Regional Office, who instead of investigating rehearsed what the branch said. When he approached its HO, the Inspection department conducted the investigation and the entire fraud came to light. Meanwhile the original Branch Manager had taken voluntary retirement and absconded from town.
   7. It took for more than 6 months for the depositor to get his claim settled, and that too, without additional interest for extended period from maturity.
   8. If the FD was non cumulative, the depositor would have known non payment of quarterly interest into his Savings account, and the fraud detected early. Alternatively, the depositor may ask for “Certificate of Non Encumbrances” from the Regional Office sending them a copy of your FD received.
   9. The best course is to maintain account only with large branches or Main Branch where the chances of such irregularities are almost non existent.

SAVINGS ACCOUNT:

Same as above.  However make sure that you know the bank’s Minimum Balance requirements, Otherwise they go on debiting your account every quarter with Rs 750/quarter. I have bad experience with Axis Bank in Mumbai, India. I opened NRI-PIS account with them with one ordinary NRE where I was maintaining decent 6 figure balance and another sub account for stock purchases. They disabled my Internet access on some fictitious ground. After a year and half, I realized that my account was debited 6 times with the bank charges of Rs 750/Qtr or Rs 4500 over 18 months. I tried to close my account, and lodged a strong complaint, that my relationship balance was 20 times their minimum balance required. But no one listens – you have to press 1, 2 4 5 6 and what not and finally told that it was a call center.

A new Manager assured me proper service again and refunded Rs 1500 only. Again, for last quarter, I was debited with Rs 750 again. I am going to close down my all accounts with such glossy electronic banks who do not know the basics of banking. (I was a banker for 19 years, so I know what is called Banking!)

The purpose of referring above episode is to help you understand that banking is not what it used to be 10 years ago. Modern day MBA bankers are too procedural to meet the requirement of ordinary depositor. Make it a habit to check your bank account regularly so that no charges are improperly levied.

CURRENT ACCOUNTS:

Same as above.  This is non interest bearing account, so avoid keeping large balances. Instead, keep major portion of your balances in Savings account so that your deposit earns some interest.

MANDATE FORMS

Some banks, especially in India, have a facility of “Mandate Form” under which you may authorize signing powers to known third person (mostly in your family) without executing complicated Power of Attorney document.

As far as possible, try to avoid joint bank accounts with some third person with only intent to authorize him to operate your account for sundry purposes. Use Mandate form instead, which can be cancelled at any time, if you find inconvenient or your account is not properly administered.

There is a legal risk too in opening Joint account with third person for only operational purpose. By opening joint account, he earns the status of being joint owner or co owner of the funds. If he runs into financial problem, your account could be subject to court seizure or attachment. If he holds “mandate power” nothing happens or could happen to your account. He is merely authorized signatory, not co-owner of the account.

RECURRING DEPOSIT ACCOUNT – Sure way to build wealth:

This kind of facility is only available in India, not in advanced countries (they are not that advanced). This account is the most important savings instrument available to individual investors on long term basis. This is like an Imprest system under which you contribute some amount every month and receive lump sum at the end of contracted period.

This account helps you manage the following:

1. One can lock in higher interest rate for 5 to 10 years with meager sum.
   1. Example: Supposing one is in era of high interest rates, say 15% on long term deposits. The rates have stopped rising and may fall.  One wants to lock in such rate with minimum cash outlay. He can open 5 different RD account with maturity of 5,6,7,8,9 or 10 years contributing say, 1000 per month. He has to pay just Rs 5000 every month for which he can give standing instructions to debit his Savings account monthly. Now look at the maturity scenario:

Simple Yield = {Interest Gain / (Average Investment) %} divided by No. of years

(Average Investment = Initial Investment (=0) + Final Investment /2)

1. It will be observed that current yield of 10% become compounded yield of  12% to 14%
2. Above method ensures steady cash flow after 5 years in greater proportion every year
3. If you plan from the age of 51, to retire after the age of 60, you will have steady cash flow every year from 77000 to 205000 per year, enough to pull on without much external support. This is your self made Provident Fund on which you have total control
4. You can vary the amount in multiples of 5 or 10 to make larger sum available to you at later age.
5. You can also open separate RD account for each activity, Children’s college education, wedding or purchase of property. Say in above case, you contributed Rs 10000 for 10 years for your children’s education, you will get Rs Rs 20 lakhs after 10 years, when they are about to get into higher education. No more educational loans at that time which will reduce your net worth. This will enhance your net worth…
6. In 1992 to 1994 FOREX crises in India, one bank offered very long period RD (for 20 years). By depositing Rs 5000 per month for 20 years @ 13% interest rate, one would get   5,619,929 against total investment of 1,200,000 (240 x 5,000) netting simple yield of 36%.  Longer the period, higher the simple yield. The average investment is worked out on this basis: Initial Investment is ZERO, Final Investment = Installment x no. of Months in a period. Divide it by 2 to have average investment over the period.
7. In short, if you plan your cash flow from early age, you will have worry less future, be it education for your children, their wedding, purchase of property or own retirement.

How to use Recurring Deposit (or Remittance) to avoid Exchange fluctuation?

While living in Hong Kong, I came across hundreds of instances from local people who always complained about exchange loss due to currency devaluation against USD. They also tried to time the remittance, and always failed. I used to tell them to send the remittance periodically taking out advantage of weaker destination currency. See the following example (we used Indian Rupees for illustration purpose. You can replace it with your national currency.)

Say, you remitted USD 10,000 @ Rs 50, 46, 44, 39, 43, 48, and 49 on seven occasions.  The average works out to Rs 45.57, marginally lower by 7% over 7 years or just 1% per year.

The people always average down, never average up. This is where they lose profitable opportunity.

Anil Selarka
Hong Kong, 21^st August, 2009

Ref: 0908-031A          For PDF file Download from SCRIBD

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Another article SR 05  on Bonds (Zero Coupons) in continuation of series ” How to Invest into Anything? “will appear on 31^th August.

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