ATM :: Should one use bonuses to repay loan or invest in equity?


Recently in an interview, an expert recommended that the Diwali bonus should be invested in equity instead of repaying the home loan.
AMIT TRIVEDI Author & Founder | Oct 06, 2014, 05.02 PM IST | Source: Moneycontrol.com

ATM

Recently in an interview, an expert recommended that the Diwali bonus should be invested in equity instead of repaying the home loan. His logic was very simple: on the home loan EMIs, one gets dual tax advantages whereas equity looks poised for a multi-year bull market.

As anyone can understand, and that seems to be the argument of this expert that as long as your cost of borrowing (the interest paid on loan) is lower than the expected return on investment, borrowing money to invest is a brilliant idea. Evidence suggests that if you were looking for safe (or guaranteed) returns, you would have to settle for return on investment that is lower than your cost of borrowing. Take a look at the rate at which a bank gives loans and compare the same with the interest the same bank offers on fixed deposits. On the other hand, higher returns would not come with safety. Some amount of risk must be taken – this risk may result into negative returns – may be temporary or permanent.

Coming back to the expert’s advice, can such a generalized advice be applicable to all?

Let us look at certain scenarios.

First of all, let us start with a secular bull market – a multi-year bull market. The last time we saw one in 2003 to 2008. Sensex closed on 25th April, 2003 at 2,924.03 points to go up to 20,873.33 (day’s closing value) on 8th January, 2008. What a rise! More than 7 times in less than 5 years! If one is looking for an example of a multi-year bull run, this was it.

Was it really a smooth journey? The graph above looks quite a smooth upside movement. However, if we look at the first 14 months, the picture looks different.

And now compare the graph with the present times. Currently, Sensex is around 50% up from last year’s low point. If we take a similar number for the above, it would be Sensex level of 4,500. This level was achieved in October-2003. If someone entered at that time, by June-2004, one was back to the investment value.

This would have been a period of extreme stress for someone who chose not to repay the home loan and invested in equity markets. One must also remember that this was a time when the interest rates were rising, which is different from the current times – at least the rates are not increasing now.

Then again, there was an almost 30% drop in May-June-2006.

It is in such times that the investor’s individual situation must be considered. What if the investor has enough to survive through this period? What if he doesn’t have enough? In the absence of such a provision, the investor runs the risk of taking money out of equities if an emergency need arises. With a home loan outstanding, and EMIs to pay, it becomes even more important to stay clear from volatility.

While equity may be a good vehicle for wealth creation over a long period, it is essential that one have the ability to stay for that long period. A debt burden reduces one’s ability to stay put. History of financial markets suggests that at the heart of every financial crisis lies too much debt. This can happen in personal finances, too.

It is important to understand one’s own financial situation and not pay heed to a generalized advice. While running may be a good exercise, it may be harmful to an obese person. Personal finance is “personal”. There are different solutions for different situations.

Second, the expert appeared too confident of knowing the future. This is a different problem altogether. Financial markets are not as simple as one thinks. Very often, the markets move exactly against the popular view. This risk cannot be ruled out. At the peak of market rally in 2008, hardly anyone predicted the downfall. At the same time, at the bottom of the market in March-2009 or even last year, who thought of a bull run?

While you may listen to the experts’ viewpoints, the final decision cannot be outsourced, since the consequences of the decision cannot be outsourced.

The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions. He can be reached at amit@karmayog-knowledge.com.

Source : http://goo.gl/r9TjUM

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