Apart from risks of investing in overvalued stocks, investors at this point of time will also have to look at various constraints of investments, in terms of taxation on equity, liquidity and the time horizon to meet financial goals.
At a time when both equity and bond markets have become volatile, investors have to do a fine balancing act. While taking risks in equity investing is important, one must understand what kind of risk one is taking for long-term returns. Apart from risks of investing in overvalued stocks, investors at this point of time will also have to look at various constraints of investments, in terms of taxation on equity, liquidity and the time horizon to meet financial goals.
Risks in overvalued stocks
If the current price of a particular stock is too high for its fundamentals and is not at all justified by price-to-earnings ratio, then stay away for some time. In times of market volatility, such stocks are most likely to see a sharp drop in price. Analysts say overvalued stock in most cases experience a price slump and returns to a level where it reflects its financial fundamentals and status correctly.
Even if a particular company’s valuations is cheap, make sure that you understand the business well and know the risks associated with various macro economic issues. Macro factors like slowdown in economy, subdued consumer demand, sticky inflation and company-related factors like financial performance, business costs and leadership must be analysed before putting your money in any stock.
Look at liquidity
Before investing in any product, look at the liquidity or the ability to turn investment assets into cash in a short span of time without having to make significant losses. Diversification of asset classes is key as it can help to maximise returns for a given level of volatility in the markets.
While bank deposits are most liquid form of investing, one can invest in liquid mutual funds as they are ultra-safe schemes for risk-averse investors and will give higher returns than bank deposits. Even tax-wise, unlike fixed deposits where the gains are on slab rate, the income from mutual funds is treated as capital gains and taxed at a lower rate if the investment is held for at least three years. You can withdraw small amounts whenever required or invest more when you have surplus cash and most mutual fund houses offer online investment facilities.
Tax-arbitrage plays a key role in creating retirement corpus. Besides an individual’s overall tax rate, the tax treatment of various types of asset classes is also a consideration in security selection and portfolio construction. For taxation, the holding duration for long-term capital gains differs depending on the asset. For equity, it is one year, real estate for two years and for debt it is three years. However, equity and real estate take longer time to give higher returns. With Budget 2018 re-introducing long-term capital gains tax on equity, look at various ways to minimise the tax impact. Instead of managed funds, look at index funds, as they are cheap and do not carry fund manager risk.
Dividends will not be tax-efficient
Many investors, especially the retired, prefer dividend income from mutual funds. However, dividend from equity-oriented funds including balanced funds will now be taxed at 10%. This will mean that investors will have to do some rejig of their mutual funds and preferably opt for growth option. Though capital gains will be taxed, it will be paid at the time of redemption. But in dividend option, tax will be deducted every time a dividend is declared and will be applicable for both dividend payout and dividend reinvestment options. So, if you have dividend reinvestment options, switch to growth option before March this year.