I received the following question from readers, in response to my article a fortnight ago about tax-free bonds — What if I do not have the required amount of money to buy such bonds? Such bonds are offered typically between December and March. Sourcing money to make lump-sum investments during these months can be, indeed, difficult, especially if you also have to make advance tax payments. Fortunately, you can adopt an investment process that will also help you moderate two behavioural biases. How?

You should buy tax-free bonds by selling your existing equity investments. Suppose you have existing investments on which you expect to earn compounded annual return of 12 per cent to reach your investment objective in 20 years. If your investment in any year has unrealised gains in excess of 12 per cent, sell your investments to capture the excess return only.

That is, assume your Rs 10-lakh investment is expected to earn 12 per cent a year. If you have unrealised gains amounting to Rs 5 lakh, you should sell Rs 3 lakh worth of investments and use the money to buy tax-free bonds. That way, you let your existing investments, now Rs 12 lakh, grow at the required rate of return and yet have the money to buy tax-free bonds.

house-money effect

The above process also moderates two behavioural biases you might suffer from. First is the house-money effect. This refers to the possibility that gains on your investment (Rs 5 lakh) will prompt you to take risky bets subsequently. By taking away the gains and investing in stable-returns investments such as tax-free bonds, you are moderating the possible risky behaviour. The bias is called house-money effect because you may perceive the gains as a gift from the market, just the way you feel when win against the house in a casino.

The second bias you can moderate is the regret effect. What if you accumulate unrealised gains and the market declines, as it did in 2008? The missed opportunity of locking-in to your gains will cause regret. And this regret can prompt you to make conservative choices subsequently, such as investing in fixed deposits. Such choices, needless to say, can hurt your investment objective, as interest on fixed deposits is not enough to beat inflation.

You can also sell a higher proportion of your equity investments (Rs 5 lakh or more based on the above example) and use the money to buy tax-free bonds, if you want to reduce your investment risk. But remember, your investment horizon should be more than 10 years; for only then will the typical tax-free bonds make economic sense.

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