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Sunday, October 5, 2008

Start your own risk free FMP

We have now spent 9 months in a bear market. For investors who had entered the markets in the last 5 years, this is the first experience of how a bear market can destroy wealth.

What we saw in 2004 and 2006 were just bear phases in a bull market, which provided opportunities to buy.  Many small investors jumped in to buy in March and July this year - only to see that there was no real recovery in the markets.

Experts have now started talking about a 4-digit Sensex, and investors who have been in denial for the past 9 months are now thinking and talking about how to protect capital and reduce losses.

The mutual fund industry has been promoting Fixed Maturity Plans (FMPs) of 12 months+ duration and trying to explain the benefits of lower tax against a bank fixed deposit. Of late, they have even started offering 1 month FMPs - and are not mentioning anything about tax benefits!

A small investor trying to protect his capital should start his own FMP and make it completely risk free. How? It is so simple, that it is almost a no-brainer.

Let us say you have some investable cash of Rs 2 lakhs. What are your options?

a) You can buy shares at low prices and watch them go lower;

b) You can buy MF units and watch their NAV drop

c) You can park it in a bank FD for 2 years and earn 10% interest

d) Start your own FMP - start with Option (c) above, but take monthly or quarterly simple interest. Depending on your risk tolerance, set up a recurring deposit (RD) account with 20% or 50% of your monthly/quarterly interest. The balance interest should stay parked in your savings account for periodic purchases of shares and/or MF units. 

After 2 years, when your FD matures your entire capital will be intact, the RD account would be intact as well, and the shares or MF units that you purchase should start showing some real gains, as this bear market should be history by then.

Simple, isn't it? But exciting? No. But who said building wealth is exciting? It is a slow and steady and disciplined process to be carried through for many years.

(I try to preach what I practice. In Oct '07, I had sold a percentage of my holdings in shares and MF units when the market looked overbought. With the proceeds, I opened a 3 years FD with a leading private bank. 20% of the quarterly interest earned is reinvested in a RD. The balance interest is accumulating in a savings account. I have slowly started to reinvest in shares and MF units.)


Maverick said...

Must say, Nice strategy Subhankar. But why are you including a RD in the loop?

Subhankar said...

The RD protects some of the interest earned from the FD, even if the stock or MF investments made with part of the interest goes down the tube.

I've also found that periodic availability of lump sum amounts - such as after the FD and RD matures - comes in quite handy not only for reinvesting but also for unexpected cash requirements.

rominder said...

what about taxation of bank fd?
33 %..again rd taxation ? what are the net yield of this strategy post tax?

Subhankar said...

Yes, both FD and RD returns are taxable, at rates depending on one's tax bracket.

But the idea behind the suggested plan was to protect your capital in a bear market - tax is only paid on the interest earned.

Many FMPs launched by mutual funds resulted in loss of capital for investors - particularly due to investments in the real estate sector by the FMP schemes.