Loan vs Redemption of Mutual Funds

In our lives, we will occasionally face the question, “Loan vs Redemption of Mutual Funds”. Suppose I want to buy a home the question arises, “should I take a home loan or redeem a mutual fund investment”? This question is quite deep, complex and serious. We need to discuss it carefully and in detail.

Loan is Bad

Undoubtedly debt, in general, is bad and you should avoid it. Value Investing exhorts to shun commercial borrowing as you would plague. The careless habit of borrowing and use of credit cards will create an unbearable debt burden. I feel sad seeing a number of bright youngsters working in wonderful companies and drawing handsome salaries but borrowing beyond their means through multiple loans and credit cards. They struggle to pay monthly EMIs and manage them by juggling through various cards.

Can we totally avoid taking loans? 

No, we can't always avoid a loan. Any useful and long-term expenditure that involves huge upfront cash outflow and which is beyond one's means may need taking a loan. Following are a few examples relevant for India:

1. Purchase or construction of a home - Avail a home loan
2. Buying an automobile - please note carefully my advice about cars later in this post
3. Child's higher education

Daughter's marriage is expensive and a big responsibility in India. Son's marriage is no less but compared to the former it is lighter. Please don't think I have gender biases - I have none. On the other hand, I have great respect for and confidence in girls. Still marrying off a daughter in India is a big responsibility.

I don't recommend borrowing for marriage. It is better to do the marriage function from savings. Like breaking fixed deposits created for this purpose. In the extreme instance, you may take interest-free loans from the organisation where you work or relatives and friends. You may ask me why this distinction even though the daughter's marriage is a huge, long-term and one-time cost. The reason is while the other situations I described above have some material utility daughter's marriage is a pure personal responsibility and expense

How to decide between loan vs redemption of mutual funds?

Don't Redeem Mutual Funds for Short-term Needs

Mutual fund investments are long-term investments. History shows that over very long periods of time mutual funds create unimaginable wealth. So to redeem mutual funds to meet short-term needs is squandering a valuable opportunity to create wealth.

So what are short-term needs? Here are a few examples:

1. Paying a child's monthly school fees
2. Going on a vacation
3. Paying the monthly loan EMI
4. Paying credit card dues
5. Paying personal Income Tax

I have listed only a few examples. I urge you to make a more exhaustive list for yourself. 

You should meet short-term needs only through your regular earnings. You should never redeem mutual funds for them.

In order to easily meet short-term liabilities, you have to learn to live a simple life. You should avoid the urge to splurge. My guru Warren Buffett says, "If you buy things you don't need, soon you will have to sell the things you need".

Redeem Only for Purchasing an Equally Long-term and Appreciating Asset

You should never redeem your mutual fund in your lifetime. This is my firm view. However, if you ever have to redeem, it should be for an equally long-term asset with the same attractive capital appreciation. For example, purchasing a home or a high rent yielding immovable property.

Even for buying immovable property like land and buildings, I don't recommend redeeming mutual fund. But if there is no other way we can at best pardon it. Let me narrate experience in a similar situation.

I was buying a piece of land in Uttarakhand for constructing our retirement home. The price was eight lakhs. I broke down fixed deposits lying in banks and mobilized from other sources. There was a final gap of one and a half lakh rupees. My wife was having a mutual fund a Systematic Investment Plan (SIP) actually, valued three lakh rupees. With a heavy heart, I asked her to redeem half of it. We purchased the piece of land. I have taken a home loan to build the house. So if we look at it we redeemed a mutual fund but only a small part of the project cost.

Don't redeem mutual fund to buy a useless, depreciable asset like a car

Buying a car is a bad idea. But in India where public transport is not ideal, an automobile is essential. However, don't buy expensive and luxury cars. Further, keep the car for at least 10 to 15 years. Don't keep changing cars or models often say in three to five years. 

The car is a highly depreciating asset. The moment it comes out of the showroom it will lose 10 per cent of its value. The value further depreciates ten per cent every year of use. I have not counted the expenses of petrol, repairs and insurance yet. 

Finally, it is not an asset but actually a liability.

Don't redeem your valuable mutual fund to buy an actual liability like the car.

Summary

The 'Loan vs Redemption of Mutual Fund' is a tricky question. Both loans and redeeming mutual fund shall be avoided. Under certain circumstances, they may be sparingly used as described above.  

What is Return on Equity (ROE)?

Return on Equity - Meaning/ Definition

Return on Equity (ROE) / Net Worth (RONW)’ is a financial relationship. It measures what a company earned as a profit on its equity capital or net worth.

Profit in this definition means the net profit after paying the income tax. 'Profit After Tax (PAT)' is another name for net profit.

Equity capital here does not mean just the amount of equity share capital. It also includes the reserves (profits accumulated over the years). This total equity share capital and reserves is also called the ‘Net Worth’. This is also called 'shareholders’ funds'. Thus net worth is the sum of equity capital and reserves. It belongs to the equity shareholders. Shareholders here mean the ordinary or common or equity shareholders.

The profit a company earns employing its net worth in the business is the return on equity. It is a percentage. It is the percentage of profit the company earns on its net worth.

Return on Equity - Formula

We calculate return on equity by dividing the net profits by the net worth. Please see the formula:

A beginner wonders which net worth figure to use. Should we use the net worth standing at the beginning of the year or at the end? A company employs only the funds available at the beginning of the year. Therefore it is fitting to use only the net worth standing at the beginning of the year. I use the net worth number standing at the beginning of the year. Now let us see an example for calculating the return on equity.

Example

I use the financial statements of 'Hindustan Zinc Limited' for my example.

Please note that I have used the net worth figure standing on the 31st March 2016. Whereas I have used the profit earned during the financial year 1st April 2016 to 31st March 2017.

Why Return on Equity is Important?

Return on equity is very important for an investor. This is because ROE measures how efficiently a company uses its capital to generate profits. It indirectly measures at what rate your investment is likely to grow in the long term. As I have already emphasised many times before, the miracle of compounding is the real trick behind successful investing. In fact, all investing.

Let us consider the following example to understand this concept.

Two companies A and B are available for purchase for a lakh (hundred thousand). While Company A has an ROE of 15% per annum Company B gives 7.5%. Let us see how they fare over a long investment period of 35 years.

After 35 years the net worth of Company A would have multiplied 153 times. Whereas the net worth of company B would have grown by a mere 12 times. The difference is a whopping 1000% or ten times.

If you observe carefully the difference between the two companies was narrow after five years (Rs.2,31,306 of Company A versus Rs.1,54,330 of Company B). However, the gap widened dramatically over a  long period of 35 years. This is the result of the working of the compound interest principle.

How Does this Matter to the Investor?

You may be wondering why small investors like you and I should care about all this. Well, it seriously concerns us and our investment. Suppose you had bought Company A for rupees one lakh 35 years ago. This means you paid a price equal to one time the net worth of the company. Further, suppose you want to sell the company now. Let us assume that the buyer is willing to pay you as per the same formula of one time the net worth of the company. You will end up receiving a sum of rupees 153.15 crores. Whereas your neighbour had purchased Company B at the same time for the same price of a lakh of rupees. Now he too sold his company and got the compensation as per the same formula. He will end up receiving just rupees twelve crores.

We just assumed that the market had offered only one time the net worth (price to book value for all the shares of the company). However, we know very well that often stock markets are highly enthusiastic and offer even three to five times the book value. If the market offers five times the net worth of the company you would end up encashing your investment of just a lakh of rupees at rupee 765 crores!

So would you buy Company A or Company B? Do you realize the importance of return on equity in the area of investing?