VR Logo

What Lies Beneath

Investors should look more carefully at the components of a financial product rather than its packaging…

Do you remember reading about the periodic table of elements while in school? If you remember this fundamental bit from your school chemistry classes, then that will help you appreciate what I’m going to write about understanding your investment portfolio, as well as choose the right kind of investments.

The periodic table of elements is a device that initially helped scientists make sense of the bewildering variety of elements that seem to occur in the world. It helped scientists organise elements in a framework that organised them into categories that made sense according to their physical and chemical properties. The existence of the framework was also evidence that there must be a deeper underlying mechanism that drives those properties, thus showing the path towards understanding the structure of the atom.

The basic idea is that a system with a large number of types can become simpler to understand and analyse if you could break up each type into its constituents, analyse each of those constituents individually and thus understand how each type works. This would help you understand each type.

Most importantly, it would also give you a way of understanding new types that you may across without needing to bother about its externalities. You can break it up into its components and understand it better.

It should be obvious by now that understanding financial products can work quite well on the same principals. In fact, this method seems tailor-made to understand financial products. So let’s try and figure out a periodic table of financial products that are available to you as a consumer.

There are only a handful of basic asset types, primarily equity, debt and perhaps commodities. There’s also insurance cover that’s available in many products. These elements have a few other properties that matter. Equity can be of companies of various size and various sectors. The debt can be of various maturities and safety levels. There’s also liquidity, or how quickly can you get your money back.

Remarkably, our periodic table for understanding consumer financial products is almost complete, a good deal smaller than the 118 elements in the periodic table of elements. Let’s put it through its paces by deconstructing a few common financial products.

Consider a bank savings account. A 100% debt product, perfect liquidity, very high safety. Shift to a bank fixed deposit. 100% debt, very high safety but much poorer liquidity. How about equity mutual funds? All equity, potentially high returns, poor safety, but high liquidity.

This method of decomposing financial products is very useful in figuring out complex financial products that are composed of different types of financial elements. Consider a ULIP from an insurance company. It’s designed to look as distinctive from other ULIPs as possible. However, it’s composed of the same elements. It will have some equity, some debt and some insurance cover. All of it will be packaged with some liquidity constraints.

Compare that to a hybrid equity-debt fund from a mutual fund company. It also has some equity, some debt and might have some liquidity constraints if it’s a closed-end fund. If you were to consider the elements alone, might it be possible that a balanced fund along with a term plan may be functionally identical to a ULIP while having better liquidity or cost characteristics. Similarly, the combination of an equity fund and a fixed deposit may deliver what you want better than a balanced fund that has the same mix.

This is not to say that I’m actually recommending any of he above substitutions. I’m demonstrating that investors would do well to not look at the packaging of a financial product but the components inside. All financial products are composed of a remarkably small number of elements. Being able to readily figure out the elements and then see how they combine to form a compound is the only way to understand what you are being sold and what it is actually delivering to you.