LIC--notional gains & Losses

25/11/2010

It’s the decade of black holes!

Another black hole was discovered in LIC a couple of days back after one was discovered in Employees Pension Fund scheme, 1995.

It was admitted by officials of LIC that 3 of its guaranteed returns schemes were facing a shortfall of about Rs. 14000 CRORES. These schemes –assures a guaranteed return of 12%---were launched in the hey days of high interest rate regimes.

However, with interest rates plummeting to single digits, the gap --between what the assets of the schemes expected to realize at maturity and what they actually realize-- is a big one and growing daily. Every fall in the interest rates will only widen this gap.

Rather than take corrective measures (which are extremely remotely possible) LIC has like the CWG officials keeps chanting aal is well. The reasoning it has put forth is unexpected from an organization of the likes of LIC. It has said that:-

• The losses are notional; and
• The losses will be made good by surplus of some other plans.

It is rather strange that even the financial crisis of 2008 has not taught any lessons to the LIC top brass or our watch dogs when they dismiss the so called “notional losses” as not so important! Why don’t they ignore the gains of other schemes in the same manner as they are also notional? That notional gains should be enjoyed as the EPF board trustees showed us when they declared a higher interest rate of 9.50% --just because they discovered Rs.1700 odd crores of notional gains tucked away somewhere in their books.

The existence of this gap—albeit notional at present—is not something to be wished away. It is like a time bomb ticking away….it is only a matter of time before it explodes.

A gap between the realizable returns and guaranteed returns is very much real and will in all likelihood expected to grow at an exponential rate. The simple reason being that fixed income returns in India are likely to remain below 12% --as is promised by the schemes---for the foreseeable future.

The gap will most likely be around 3% if not more. With the schemes having still got a few decades to run, this 3% gap will grow to about 80% in nearly 20 years. However, a lic policy holder need not worry as long as they have the following support base:-

• Holders of those policies which are in surplus (so what if you have to subsidize the loss making policy with your surplus)
• Government of India

No matter how much LIC mis-manages its investments or policies, at the end of the day it can always run to its big daddy—Government of India—for a bail out. And the best way for the government to make good its losses---impose a cess/tax. Taxpayers are meant to be milked!

CRASH IS WELCOME!!

If there is one question that everyone wants answered, it is regarding the plan of action in such market turmoil. How does one get through this crisis?

Actually, there are just two avenues to explore.

First, you can sell your investments and sit on cash or channelize the money into fixed return instruments. Not only is this not very tax efficient (the returns from fixed income instruments are taxed) but you also lose capital since you are selling at very low rates.

Cashing out closer to the bottom is disaster from an investment point of view. Even if you go ahead, you will not know when to begin reinvesting down the road. The odds are against you when you attempt market timing.

Your second option, and definitely the most preferable route, is to stick with your long term plan since this crash will actually benefit you. Because in the equity market, you make money not despite the crashes but because of the crashes.

Let’s look at the tech boom. The Sensex touched around 5900 in February 2000 before sinking to 2600 in September 2001. It touched 6000 only in January 2004.

Now let’s assume that the crash never happened. The Sensex reached 5600 in March 2000 and stayed at that level till October 2004.

If you had started investing Rs 20,000/month in a Sensex-based index fund in early 1997 and continued all through, your investments would have been worth Rs 55 lakh (without the crash) instead of Rs 66 lakh (with the crash). The reason? The crash enabled the investor to buy cheap and thus eventually raise total returns.

If you are investing steadily for the long term, then intermittent crashes help you make more money, not less. Because when bubbles correct, they usually overcorrect so that the market is selling well below fair value. So that’s the time to go buying, not selling.

Discipline--Key to Equity Investments

We at AIMS have always believed that equity is the best asset class in the long run. History is replete with numbers/figures to support our belief, as after all history does not lie.

Over the last decade, Sensex has given an annualized return of about 18%. The numbers of equity funds that have been around for that kind of time period have done even better. To give you a brief idea of the wealth generated by Mutual Funds since 01/11/2000 till 31/10/2010:-

Fund Name		Returns CAGR (from 1/11/2000)
DSP BR Opportunities Fund	:-	27.73%
DSP BR Equity	:-	27.68%
HDFC Top 200 Equity Fund	:-	32.12%
HDFC Equity Fund	:-	32.10%
HDFC Growth Fund	:-	25.46%
Reliance Growth Fund	:-	36.13%
Reliance Vision Fund	:-	32.60%

These kinds of returns can generate serious wealth without much of an effort.

Over the past 10 years, a saving of Rs 20,000 a month at typical fixed income interest rates would have left you with just Rs 36 lakh while a SIP in a typical equity fund would have left you with around Rs 1.20 crore. That’s the kind of differential that can change someone’s life for better.

However, you will hardly come across anybody who has realized/generated this kind of wealth by just being a passive investor! We get so worked up trying to predict the sensex level and try to ride every peak and bottom that we more than often forget the basic purpose of investing; whether it is to fund our children education, marriage, our retirement etc.

Rather it is an irony that we have come across far more people who have managed to either lose money or gain very little while investing in equity. Why is this so? If equity investing is such a wonderful thing, why aren’t the streets full of ordinary investors singing virtues of the stock market? We believe that the answer lies in the large gulf between the theory and practice of equity investing.

The returns as shown above can be yours if the investors follow but a simple rule, viz;

· stick to the straight and narrow.

· Invest in a mix of stable large to large-mid stocks;

· invest regularly to average your cost and keep investing for years and years, and

· most importantly, don’t stop investing when the market is down and don’t invest more when the market is up.

Most likely we just end up doing whatever our instinct tells us to do and that the theory remains without practice. We still get queries for SIP like:-“I’ve been investing in SIPs for more than a year, should I book profits now?”

Queries like these arise since investors still equate SIP investing in particular and equity in general with short term betting and thinking that 1 year is long term!

The fruits of equity investing are available to everyone, but we’ll have to figure out how to peel that fruit.