Let us start this post with a question. Why do we need money? Money has two basic uses. We need money to fulfil our current needs like buying food, paying bills, rent / mortgage etc. We also need money for our future needs. Whether your future needs are known or unknown, your money must grow if you are to meet your future needs. Why must money grow? There is a concept in Finance known as the time value of money. The value of Rs 100 today is more than Rs 100 one year or even one month from today. In order to get the same utility from money in the future, money must therefore grow. If money does not grow, then it is idle money.
Do you have idle money?
If you save but do not invest, you will have idle money. We earn money and spend it on our daily (or monthly) expenses. If we spend more than we earn then we will be in debt. Fortunately, most people in our country spend less than they earn. The unspent money is our saving. Some money is kept as cash in wardrobe safe-boxes, almirahs, cupboards, trunks etc for rainy day needs or festive shopping. Many of us, including me, thought that, this was a practice from the 50s and 60s, but the stories in the media in the wake of demonetization shows that, this is still quite prevalent in our society. Unspent money, in most cases however, idles away in our savings bank accounts. Unlike money kept in the almirah locker, the savings bank money earns some interest, but it is much lower than the inflation rate.
Difference between saving and investing
Many people think saving and investing is the same thing, but they are not. Money kept in your almirah locker or your savings bank account is saving but not investment. When you save, you do not expect your money to grow, whereas when you invest expect returns and your money to grow.
There are other differences between savings and investments. Savings are more liquid, which means that, you can use the money whenever you want. If you have cash in the almirah safe in your home, you can open the safe and use it, anytime you want. If you have money in savings bank account, you have to drive or walk to your nearest ATM and draw cash. If you have a debit card, you can make purchases using it. An investment on the other hand is not as liquid. You can withdraw money from your investments only during business hours though some mutual fund products offer almost as much convenience as savings bank (we will discuss this later in the article).
Inherent in the difference between savings and investments is the notion of risk. Savings are thought to be risk-free, whereas investments are thought to be risky. However, the notion of risk is often flawed.
What is risk? Risk is the fear of losing your money. When your savings are in the form of cash or savings bank balance or any other form of savings (like Bank Fixed Deposits, Post Office Savings Schemes etc), there is no fear of losing your money.
But have you considered inflation? Suppose you have Rs 10,000 in cash kept in your almirah safe or savings bank account for some future use (say one year from now). After a year, your Rs 10,000 will still be Rs 10,000 if you kept it as cash or at best Rs 10,400 if you kept it in a savings bank account (assuming 4% interest rate p.a.), but what costs Rs 10,000 today will cost Rs 10,500 or Rs 10,600 one year from now(assuming 5 – 6% inflation). You should also understand that, risk is not binary. There are different grades of risk. The risk levels of liquid funds, income funds, Monthly Income Plans (MIPs), balanced funds and equity funds are different.
Opportunity cost of money sitting idle
Many of us have money sitting idle in either in the form of cash or savings bank balance. The question we need to ask ourselves, why cannot we put this money to more productive use? We have to understand the opportunity cost of not investing. I know of a person in my extended family, a home-maker, who accumulated a few Lakhs over a period of time, for her daughter’s wedding jewellery by saving a few thousands from her monthly expense budget by keeping the money in the safe of her almirah. The rest of the family did not know about the savings and everyone in the family was elated with the jewellery she gifted her daughter. But was it the best course of action for her? I am afraid not. Let us assume, she saved Rs 3,000 every month. Over a period of 10 years, she would have accumulated an amount of Rs 3.6 Lakhs, with which she would have bought a wedding gift for her daughter.
However, if she invested her monthly savings in a diversified equity mutual fund through SIP, she could have accumulated a much bigger amount. If she had started a monthly Systematic Investment Plan (SIP) of Rs 3,000 in a good diversified equity fund, she could have accumulated Rs 6.5 Lakhs (assuming a return of 11%, which was return of average diversified equity funds over the last 10 years). The opportunity cost is simply too high. Even if she kept her unspent money in a savings bank account, the savings bank balance would have been much smaller than what she would have got through the mutual fund route.
Many people do not know where to invest their money and keep their money idle in savings bank account. You should analyze how much money you need in the short term for defined needs or for contingency planning. If you have a defined short term need, then you know how much money you will require for that particular short term need. If you have money stashed away for contingency, then you should have a plan of how much money you need in the event of a contingency; usually 3 – 6 months of expenses should be kept as a contingency fund (though not necessarily as cash or savings bank balance; there are better avenues). If you have more money in your account than what you need for your short term needs, then SIP in a good equity fund is a good option for investing the money.
Safety and Liquidity
Safety and liquidity are often cited as concerns by people who keep large amounts in cash or in their savings bank account. Do you know that, money market mutual funds are quite safe and highly liquid? Money market mutual funds are the safest and most liquid of all mutual fund investments. They can be compared with a high yield savings bank account. While most savings bank accounts pay 4% interest per annum, current money market fund (e.g. liquid, ultra-short term debt fund) yields are in the range of 7.5 – 8%. Therefore, they are great investment opportunities for funds lying idle in your savings bank account.
Redemption request in money market mutual fund units are processed within 24 hours on business days and the money is credited to the investor’s bank account. I know smart investors, who park most of their monthly income in liquid funds or ultra-short term debt funds and then draw on a weekly basis for their regular needs, with a little more planning. The extra returns earned from the short term investments can make a big difference in the long term.
Some investors may consider the 24 hours turnaround time a small inconvenience, since you can draw money from your savings bank account by visiting your bank branch during banking hours or from ATMs at any time. Some money market mutual funds (e.g. Reliance Money Manager) offer instant redemption capabilities. Money market mutual funds offering instant redemption capability will credit money to your bank account within a few minutes. With the instant redemption capability investors can now draw money from their investment instantly on all days at any time. The instant redemption capability in select money market mutual funds make them as convenient as savings bank, while offering much higher yields.
You can also explore arbitrage funds for your short term needs. These funds, as the name suggests, are virtually risk free and offer very good returns. Arbitrage strategies exploit the market inefficiencies between cash and derivatives markets or between index and basket of stocks or between stock exchanges. Arbitrage opportunities are usually higher when the market volatility increases. Arbitrage funds are highly liquid and from a tax perspective are treated like equity funds and enjoy the tax advantages of equity funds. Profits from arbitrage funds held for a period of more than one year are tax free. Dividends paid by arbitrage funds are also tax free. Even for investments held for less than a year, arbitrage funds are more tax efficient than most other traditional savings options; short term capital gains in arbitrage funds are taxed at 15%, whereas investors in the 20 – 30% tax bracket have to pay higher tax on interest from most traditional savings options.
Multiple solutions with mutual funds
Mutual funds offer multiple solutions for a variety of investment needs and financial situations. If you have excess money from your regular income on a continuous basis, you can start a SIP in a good diversified equity mutual fund or balanced fund for the long term. SIP can help you remain disciplined, benefit you through rupee cost averaging and grow your wealth in the long term through the power of compounding.
If you have excess funds that you do not need in the short to medium term, you can invest in income funds. Income funds can generate higher returns for you than small savings schemes and at the same time, get more favourable tax treatment compared to small savings schemes.
Even if you need the money in the short term, mutual funds offer better options in the form of money market mutual funds (e.g. liquid funds and ultra-short term debt funds) to earn much higher yields, without sacrificing liquidity convenience, if you invest in the funds which have instant redemption features.
Keeping your money idle is the waste of a productive resource because money can grow over time, if invested in the right avenues. As discussed in this blog post, you do not have to sacrifice convenience for the sake of higher yields, if you choose the right product. Most of the times, we are not able to put our money to its most productive use due to lack of awareness or sometimes due to our inability to make the right investment decision at the right time or sometimes due to plain inaction on our part. Making your idle money more productive does not take a lot of effort. You should discuss with your financial advisor, how to deploy your idle funds more effectively.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.