Thursday, December 28, 2006

Plan to Bring Your Debt to Manageable Levels

Series: Beginning Investing (6th post)
Section: Before You Invest

So far you have accomplished two important things - you've set your goals and also determined the amount of money you can save / invest every month in order to achieve them.

It is time now to start doing the preparatory work towards creating a sound financial plan. This section, 'Before You Invest', will consist of three posts:

  • Bringing your debt to manageable levels
  • Insurance
  • Setting aside a emergency cash

Today we'll be talking about the first of these.

Good and Bad Debt

Most of us have debt of some sort: car loans, personal loans, home loans / mortgages, credit card outstandings or just money we've borrowed from friends and family. This is in itself not such a bad thing. After all, loans serve the important pupose of letting us buy into things today that we could otherwise never afford.

The trick, however, is to distinguish 'good' debt from 'bad', a concept that I first read about years ago in the book 'Rich Dad, Poor Dad' and which has stuck with me ever since. Essentially, any debt you take on towards buying an appreciating asset (something that increases in value over time) is 'good' and any debt you take on to purchase depreciating assets (like cars, appliances etc.) or consumables is 'bad'. The idea here is to minimize bad debt and increase the amount of good debt in your portfolio.

Note that I am not talking about eliminating bad debt completely, which is probably impossible in real life. Everyone would like to buy a car or a nice TV or refrigerator and it's rather difficult to do these without taking a loan of some kind. Just understand bad debt for what it is - a drain on your savings - and work out ways to reduce this by postponing your purchase or perhaps settling for something a little less expensive.

The balance to strike here is between your current lifestyle and your future and it is up to you how much you sacrifice now so you can enjoy later. Just be aware that the more you live it up today, the less you will have for tomorrow.

'Good' debt, on the other hand, is a pretty neat thing to get into. You purchase an asset at a price locked in on the date of purchase and reap the benefits of all the profit the asset makes you over time.

How Much Debt Should You Have?

In general, most banks will not allow you to borrow any amount for which the total of your monthly instalments across all your loans will exceed more than half of your income. Most people stretch this even further by taking loans from different banks and not declaring their outstanding loans elsewhere. This is definitely too high for comfort and will leave you in a desperate position in case you were to lose your income for some reason.

I'd suggest perhaps 30% as the limit, and this includes all your debt, including any amount you are rolling over on your credit cards.

How Should You Reduce Your Debt?

Start by listing all your loans under the 'good' and 'bad' categories and, for each loan, list the annual interest rate you are paying. For credit cards, this would typically be about 40% (@ 3% per month interest), which makes it the most expensive loan you could take!

Based on the monthly savings you have already calculated, plan on pre-terminating the more expensive (higher interest) 'bad' loans. Focus on this first rather than on investing your money as this will also significantly increase your savings potential as your interest payments go down.

Further, explore the option of taking on lower cost loans to pay off higher cost loans e.g. taking a personal loan at 18-20% to pay off your card outstandings (which are at about 40%), transferring your card balance to another card to avail of balance transfer incentives, taking a top-up loan on your property (at about 9-11%) to pay off your car etc.

Especially on the subject of credit cards, if you have multiple cards with outstandings on each, plan on paying them off in the following manner:

  • Pay the minimum due on all cards except the one where you have the highest interest. If all cards have equal interest, then choose the one which has the highest outstanding
  • For this card, use your spare funds to pay off as much as you can
  • Do this every month till you have paid off the first card. Then cancel the card
  • Move your focus on the next highest interest or outstanding balance card, paying off as much as possible on this while maintaining the minimum due on the others
  • Continue till you have paid off all cards. Retain only one or two cards at a maximum

Have a Plan and Stick to It

Based on the above, create a 'debt-reduction' plan and stick to it, trying to minimize or eliminate 'bad' debt over time, thereby creating a larger monthly savings base with which to start investing once your debt is down to manageable levels.

Next Post on Beginning Investing: Insure Yourself and Your Property

Sunday, December 24, 2006

Realty Stocks Overvalued?

I've not really been tracking IPOs much of late. The main reason for ignoring these is the fact that there is almost nothing on the table for long-term investors in IPOs today.

The lack of sufficient historical information coupled with some really eye-popping valuations thanks to the bull market make me jittery, to be honest. Also, the mammoth oversubscriptions in most of these imply that the average investor gets a miniscule allocation that is simply not worth the effort. Even if you were to sell at a handsome profit on the first trading day, the absolute value of your returns doesn't make it really worthwhile.

Among IPOs, the ones I am most leery about are realty companies, which are blessed by being at the intersection of both a stock market boom as as well as a property boom and hence these companies are cashing in big time. This article illustrates the issue beautifully.

Monday, December 18, 2006

What Are Your Goals?

Series: Beginning Investing (5th post)
Section: Setting Your Goals

OK, so now you know how much you're worth, the amount you spend and the amount of money you can put away every month to meet your goals.

The question for this post is - what are your goals? And remember, these are goals you are defining, not dreams or visions like 'I want to retire rich on a little island in Spain'. They need to be tangible and down-to-earth.

There are three things you need to define for each of your financial goals: what you need money for, when you need it and how much you need. An example of a goal would be 'I need Rs. 5 lakhs to pay for my son's wedding 5 years from now'. Since it is tough to predict how much prices will rise over a long period of time, it would be easier if you just work out the funds you would need to fulfil the requirement in today's prices. You can work out the inflation-adjusted requirement later.

Sit down with your family and work your goals out in some level of detail. After you have these settled, re-order them in a chronological format, with the nearest goal first and moving down to the goals that are furthest out.

When planning your goals, do ensure you consider the following:

  • Childrens' education: Lumpsum amount to pay for a good college / post-graduate education for your kids
  • Weddings: Lumpsum amount to pay for your childrens' wedding(s)
  • Home purchase: Lumpsum amount to pay for an outright purchase or down payment on your own home plus furnishings etc.
  • Financial freedom: A point in time at which your average monthly spend should be accounted for purely out of passive income i.e. income from your investments. For more information on this, please read my earlier post on this subject
  • Retirement: How much money you need to retire so that your retirement egg will sustain you for the rest of your days

This first draft of your goals might change a bit based on how much you can realistically invest and on the level of risk you are willing to take, but that is the subject of the next post. Also, do note that these goals will probably change from time to time, depending on your stage in life e.g. you might start planning for your childrens' education once you start a family, a requirement that may not have been in your plans earlier.

But, for now, give yourself a pat on the back for getting here. You now have the entire foundation laid for building your financial plan, not a mean achievement at all!

Till next time, happy investing!

Next Post on Beginning Investing: How Could You Achieve Your Goals?

Tuesday, December 12, 2006

Is the Indian Economy a Bubble?

Characteristics of a Bubble

A bubble is caused by extraordinary amounts of foreign capital coming into a country through the banking system, leading to excessive credit creation (lending) to consumers and businesses. This allows people to consume more and businesses to expand their manufacturing capacity to meet vastly increased demand. Thus, when the flow of foreign capital slows down, stops or reverses direction, businesses are left with over-capacity, forcing them to cut prices in order to survive, wages go down as jobs are cut and consumption reduces as a result, putting further pressure on prices. This is a downward spiral and governments usually try to rescue the economy by spending like crazy and reducing interest rates, trying to stimulate demand and revive businesses. The country has to take on a lot of debt in order to do this over a period of years and is left weak and financially exhausted.

Foreign capital can come into the economy either through trade surpluses (i.e. the country exports more than it imports), through foreign investments in the stock market or through foreign direct investment (FDI) and making its way into the banking system in the form of deposits, which are lent out to individuals and businesses. And as deposits continue to grow faster and faster, interest rates fall as banks try to lend what they have. This leads to over-investment (and hence over-capacity) and over-consumption.

Key symptoms to watch for are a massive buildup in forex reserves, very high credit growth, large-scale property development, unprecedented and sharp rises in asset prices (property, stocks, art...). However, once capacity reaches a stage when supply far outstrips demand, prices begin to fall and the downward spiral begins.

The Indian Economy Today

Based on the above discussion, let's examine the Indian economy today:

Forex reserves: $140 bn, as of 2005. Note that the article says the Reserve Bank has been trying to keep exchange rates in check. This is up from $3.96 bn, in 1990, with nearly 50% having been built up in the previous two years!

Credit Growth: A per a November article in the Financial Times, credit has grown by 30% overall last year, a rate that has the Reserve Bank of India rather concerned. Of this, retail loans have growth by an average of 47% as opposed to 27% and 37% for agriculture and business, respectively. Within retail loans, housing loans have grown by 54% and commercial real estate loans by a staggering 104%. It may be noted that Thailand's domestic credit growth in the years immediately preceding the crash were in the range of 15-35%. However, India's credit to GDP ratio stands at a fairly low 45%, as opposed to the almost 300% that Japan had before its crash in 1990

Growth in Property Prices and Development: The same article states that "analysts estimate India’s property industry will be worth $50bn in sales by 2010, from $12bn last year. Property companies are reported to have plans in the pipeline worth up to three times the value of all the projects they completed in the past five years". I think these statements pretty much sum up everything. Housing prices have risen by up to 60-100% in some parts of the country in the last year alone!

Growth in Stock Market: The Sensex has risen at a long term compounded rate of around 13% from 1,000 in 1990 to around 7,000 in 2005, but it has almost doubled since then to about 13,000 in a span of just about a year and a half!

Growth in Other Assets: I've already written about the phenomenal levels of appreciation in Indian art. Gold, too, has been on the rise, though this is of course a global trend

These statistics are disconcerting, to say the least, and there are two questions that need to be answered:

1. Is India a 'bubble economy' waiting to burst? This could be determined by comparing the amount of foreign inflows as a % of GDP vs what it was for the bubble economies before they burst
Foreign investment inflows have jumped sharply from $6 bn in 2003 to $ 20 bn in 2006, as per Reserve Bank statistics, and these are about 2.5% of India's $800 bn GDP. India is essentially a net importer, so that is a non-issue.

2. Is India so heavily dependent on exports to US that the economy would collapse on a reduction in trade deficit and / or a devaluation of the US dollar? Prima facie, it seems not because India runs only about a $10 bn trade surplus with the US, which is a small fraction of its $800 bn GDP, as per Reserve Bank statistics


We're not a bubble quite yet, and neither are we very heavily dependent on a strong US dollar, so you can probably stay invested still. However, the trends need to be analyzed further to get a better assessment of where we are heading...

The story is, however, not over for you dollar-earners, as the dollar exchange rate is probably an axe that is waiting to fall.... maybe you should start repatriating some funds to India?

Tuesday, December 05, 2006

Quote from 'Reminiscences of a Stock Market Operator'

The following is such a good quote that I couldn't but share it with all of you:

The training of a stock trader is like a medical education. The physician has to spend long years learning anatomy, physiology, materia medica and collateral subjects by the dozen. He learns the theory and then proceeds to devote his life to the practice. He observes and classifies all sorts of pathological phenomena. He learns to diagnose. If his diagnosis is correct, and that depends upon the accuracy of his observation, he ought to do pretty well in his prognosis, always keeping in mind, of course, that human fallibility and the utterly unforeseen will keep him from scoring 100 per cent of bull's-eyes.

And then, as he gains in experience, he learns not only to do the right thing but to do it instantly, so that many people will think he does it instinctively. It really isn't automatism. It is that he has diagnosed the case according to his observations of such cases during a period of many years; and, naturally, after he has diagnosed it, he can only treat it in the way that experience has taught him is the proper treatment.

You can transmit knowledge, that is, your particular collection of card-indexed facts but not your experience. A man may know what to do and lose money if he doesn't do it quickly enough.

You might want to read the book, but be warned that it was written about 75 years back so you could find it a bit old-fashioned.

Saturday, December 02, 2006

The Dollar Crisis

I've been reading a book called 'The Dollar Crisis', which talks about how a rising US trade deficit is unsustainable and is sooner or later likely to be reduced through currency devaluation and general reduction in consumption and import. This will lead to severe repercussions for all export-oriented economies given that they basically survive on exports to the US (the Asian economies are the leaders in this respect, but India will also be affected) as well as other nations, since the world's reserve currency is the US dollar.

A slowdown in US imports will lead to a global slump and perhaps even a recession, creating worldwide stock and property market crashes, among other things. The good news is that prices of goods and services will most likely reduce, but if you're an investor that might not be much to cheer about! Further, if you are one of the many immigrants working in the US, I need not explain how a falling dollar will affect you. The book talks about currency devaluations of the order of 50% or more!!!

Reading all this has got me thinking about the general direction of the Indian economy, as the book provides multiple examples of 'bubble' economies, all of which showed similar trends in the years leading up to the inevitable crashes. We are all most familiar with the dot-com bust and perhaps the Asian crisis, but similar situations have been happening on a fairly regular basis e.g. Japan's bust in the early '90s, from which it is only now recovering...

The 'Crisis' In a Nutshell

Till early in the 20th century, the world followed what was called the 'gold standard', in which their money was backed by gold and, hence, redeemable as such. In such a system no country could afford to have a sustained net trade deficit as that would cause their gold reserves to deplete till it reached a stage when they no longer had enough gold to sustain their economy. Once this stage was reached, their economy would go into a recession and prices and wages would fall till they were low enough for their exports to become cheap so the rest of the world would start importing from them again, allowing their gold reserves to build up once more.

Today's system has no such checks and balances. The international standard is a set of currencies that float in value against each other, with the US dollar as the de facto reserve currency of the world. In such a situation, and with a strong dollar, there is nothing stopping the US from sustaining a large trade deficit (i.e. importing more than it exports). And since it is to the advantage of exporting nations like India, China and the Asian countries to keep their currency values low, they cannot take the US dollars they get from exports and convert them into their own currencies, as that would increase the value of their on currencies and hurt exports.

Therefore, these countries invest them back in the US and state them in the form of national reserves. Thus, the US gets goods and services and pays for them in dollars, which it then gets back in the form of investments. These investments are pumped into the US banking system, which it then lends out, thereby allowing businesses and consumers to buy more things, most of which are imported! This cycle allows the US to continue with a rising trade deficit. Thus, in effect, the US has been buying goods on credit!

This huge US trade deficit has been financing most of the economic growth in the Asian nations and other export-oriented economies, allowing for increased lending and creating jobs and wealth that are leading to economic booms and rising asset values (stocks, property etc). Therefore, a slowdown in US consumption will hurt these economies badly, leading to a very severe recession.

Since the US deficit is underpinned by the willingness of the rest of the world to continue to hold their reserves in dollar instruments, it is only a matter of time before it has to be curtailed as countries begin to get uneasy about the credit-worthiness of the US (after all, it cannot repay infinitely large sums of money) and either withdraw their funds or at least reduce their annual investments. The other possibility is that the US consumer, already neck-deep in debt thanks to all the low-cost credit they have had access to, is no longer able to service increasing debt repayments and chooses to cut back consumption, thereby reducing the extent of US imports.

Both of these scenarios spell doom for the rest of the world, as the net result will be for the US to have to sharply depreciate the dollar against countries with trade surpluses (China, India and the Asian economies) in order to reduce, and eventually reverse, the trade deficit.

The next post will focus on India