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The Simple Life
Financial products must be simple, straightforward and easy to understand. If an investor does not understand a financial product or service, then it isn't right for him, regardless of how attractive it appears
By Dhirendra Kumar | Nov 18, 2014
When one starts studying investors and investments with an open mind, it doesn't take long to understand that the more complex a financial product or service, the worse it is for the buyer. To put it another way, if an investor does not understand a financial product or service, then it isn't right for him, regardless of how attractive it otherwise appear.
This means that financial products must be simple, straightforward and easy to understand as far as possible. For example, just about the only 'investment' that is suitable as the way for a small child to save pocket money till the next month is to keep it in a box. The money is there, and when the kid needs it, he or she can take it out. That's it.
This need for simplicity can actually be extended much further. All investments are of two types-debt or equity. By themselves, debt or equity are very straightforward. Debt is the simpler of the two. You give a loan to somebody who can put it to some use, like a bank or some other business, for example. After sometime, your money, plus a little extra, are returned to you. Equity is almost as simple. Someone wants to run a business but doesn't have enough money. So you contribute some money and become a business partner, in proportion to the money you contributed. So if one per cent of the money is yours then one per cent of the profit is yours and so on.
In practice, debt and a equity (specially equity) are slightly more complex but if you keep a clear-head there's nothing that can't easily be boiled down to the basics. There could be different ways of actually investing but it all comes down to debt or equity. For instance, your provident fund is just a loan given to the government. And mutual funds are really not an investment at all but and entity to whom you give the task of investing for you.
Every investment can be fitted into and understood in this debt-or-equity framework. For example, buying a property is clearly an equity investment. In this entire picture of investments that most of us make, the oddest creature is actually insurance. The reason is that insurance itself is not an investment and cannot be simplified to any kind of debt or equity framework. Insurance by itself is just a risk cover whereby you pay a premium for a certain term and if you die within that term, the insurance company will pay your survivors. Unfortunately, from being a potentially simple idea, the buying of insurance has been made into an incredibly complicated exercise by mixing it with investment. When you buy insurance the part of your money that will go into investment and the part that will go for covering the risk of dying is an opaque mix up and the cross-flow of investment returns and risk cover is practically impossible to unravel.
The only reasonable thing to do is to keep insurance and investment completely separate by buying only term insurance, which is pure insurance. Separately, you should make investments that are pure investments and are understand as investments. This sounds like a paradox but the test for the right kind of insurance is whether the insurer will ever return any money to you. You should never buy a policy in which you get anything back. If you are getting any money back, then your policy is actually an unhealthy mix of insurance and investment. Unfortunately, term insurance is so good for customers because it's cheap and for the same reason it's a product that insurance companies and insurance agents are not fond of selling. But that's a different story.
This column first appeared in November 2006.