POSTED BY May 26, 2010 COMMENTS (70)ON
How do you find out if a product suits your requirement ? What about a very simple calculation which can take into account most important requirements like lock in factor , complexity of a product , your requirement and its return and risk potential and tells you if it really suits your requirement. This Post will talk about a concept developed by me called GFactor , which is a score system for any Financial Product. You can input 4 factors and get a score for a product . So this GFactor score system will tell you about goodness/badness of a product. Gfactor stands for Goodness Factor .
GFactor is a very simple rating system for Financial products which gives a score on a scale of 0-1 . 1 represents excellent , 0 means worse . There are mainly 4 factors which we consider when we design this GFactor .
Trap Factor is nothing but its score for the product on scale of 0 – 1 for the lock in period. The more trapped you have to be in product , the more will be the Trap factor score. One important point you should note here is that you should also consider how much loss you have to take even after you can freely come out of the product . For example : Endowment policies trap you for long periods like 15 to 20 yrs . Even though there is an option to close the policies you loose a lot of money. So the trap factor of Endowment Policies will be more like 0.9 or 1 , where as Mutual funds (non tax saving funds do not have any type of locking period) . So they can have trap factor of 0.1 or 0 . In ULIP you are stuck for at least 3-5 yrs , only after the 5th year. So it can have a trap factor of 0.6 or 0.7 you can get out without any penalties . For term insurance there is no trap factor , you can stop the policy any time .
Years of Trap
Risk/Return Factor is a factor which will evaluate a single digit score for its risk/return potential . This score takes into consideration both risk and return . You can look it as risk adjusted return potential . so this factor will determine the return potential considering the risk potential. To calculate this you should know average return and average risk figures of a product in its total duration . Lets see the calculation first .
Risk Return Factor = (Average Return – Average Risk)/Average Return
Lets see an Example in case of ULIP : Robert wants to buy some mutual funds for next 5 yrs . In these 5 yrs , as per the historical data , we know that he can expect an absolute 100% return on average (his money can double) , and if some thing bad has to happen hecan loose around 30% of value (the figures will differ for everybody) . So
Example for Mutual Funds (5 yrs)
Risk Return Factor (Mutual funds) = (100 – 30)/100 = 0.7
Example for Fixed Deposits (2 yrs)
In this case suppose the returns from FD are @8% .
Risk Return Factor (FD) = (16 – 0)/16 = 1.0
Note : For term insurance , the return will be the max amount you can get and Risk would be amount you can loose all , which is total premium over many years.
Complexity score is a number you assign to the product, depending on the how complex of easy it looks to you . For example Mutual funds can be easy to understand for me , so I can put 0.1% for it a complexity, whereas NPS is more complicated to me , so I will put 0.5 . This means If it looks too complicated for you, then give a higher score, whereas if you understand it well, assign lower score .
For a normal person I would say ULIP is complicated , so we gave give a score of .7 or .8 or 1 ,depends on you, where as term insurance is extremely easy to understand, so it will get 0 or .1 , Mutual funds would be .2 or .3
Its a score given on the fact that how badly you need or require the product and will it be the best thing for you. One person may need it more than other, so the score will be different for different people. If you are not in a hurry, but your relative suggests you a policy , then it does not become a very high priority product for you, because you do not require it at that time, so you will assign a lower score to it . For a person who is in his 26-27 age and just married and has some financial dependents , His score for term insurance will be around .9 or 1 because he badly needs it . Make sure you know difference between your needs and wants
A person who is 45 , for him/her NeedFactor for Health Insurance would be .8 or .9
A person who is Extremely High risk taker and understands equity investing well , his need factor for NSC or FD would be low , say a score of .2 or .3 because he really does not need it and it does not suit his requirement also .
TF : Trap Factor
RRF : Risk Return Factor
CF = Complexity Factor
NF = Need Factor
You should understand how the formula should be constructed. Out of the 4 variables, 2 scores shows strength of the product(Need Factor and Risk Return Factor), where as two scores are negative(Trap and Complexity Factor), so below formula should take care of this aspect .
GFactor Formula = (NF * RRF) – (CF*TF)
Lets take an example . Ajay is a 35 yrs old Indian working in a Software company, He has 2 kids and 1 wife 🙂 and 1 parent to support . His risk appetite is moderate and he cant take more than 20% downside in his investments at any given year . He has a home loan and a car loan at this moment and has just 10 lacs of overall savings . Below is the chart which calculates GFactor for some products considering Ajay’s situation. Understand that these numbers are for Ajay, it can change for you .
| Term Insurance
| Health Insurance
| Tax Saving FD
Just like we have Gfactor of a product , we can have GFactor of a Portfolio , which is average of GFactor’s of all the products in a Portfolio . Example
So average of all the GFactors = (.95 + .43 + .35 + .72 + 1 + 1)/6 = .742 . This is a good Score for a Portfolio , But I can do better than this . Whats your Portfolio GFactor ?
There are 4 main factors which matter when taking the decision regarding a Financial product , The above concept is my own thinking and It may not fit everyone criteria , but I am sure it would be true for most of the people , If you have disagreements , its fine . We subconsciously understand how there 4 factors affects our decision making process , but the idea is to put it into formula and get a Score out of it , so that we can compare and know how good or bad a product can be for us .
Note : This is an old post , I am republishing it with changes
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