Financial planning: Making wise investment choices

In the first of this four-part series N R Ramakrishnan demystified the tedious process of financial planning.

While the second installment explained how the power of compounding helps you achieve financial goals, in the third part of this series he explains the basis for choosing your investment options so that you achieve your long-term financial goals.

We have seen that first two steps of financial planning involve estimation of costs of the goals and the amount you are required to keep aside (saved) periodically to meet these goals. The final step in the financial planning process is choosing where the saving amount will be parked (investments) so that at the material time the accumulated amounts are available for satisfying your goals.

In effect what we have to see is how much is the possible income from your investments -- whether periodically received (dividend/interest) or received by way profit from sale of the asset (selling price purchase price) or a combination of both (total income). The total income divided by the purchase cost as a percentage is the return from the asset.

If the returns are normalised for 12 months we will get annualised returns or simply we will call it as rate of return.

In our case we are assuming that all the returns are also reinvested at the same rate every year till the time of actual sale of the assets and hence the rate of return is the compounded annualised growth rate. The rate of return expected from the asset is a factor, amongst others, that will determine the choice of your investment vehicle.

The return, which you get, is termed nominal return from which there will be an outgo on account of tax and also diminution in value due to inflation. The expected return should therefore be something more than inflation & tax impact put together, so that the investor is compensated for postponing her/his current consumption to future.

The expected level of inflation and the tax structure applicable for an asset will therefore be two more factors, which will determine the choice of your investment vehicle.

Some assets like equity fluctuate in a large band while bond assets fluctuate in a medium range. The assets invested in money market normally fluctuate in a very small band. The return from deposits being contractual does not show much fluctuation. The fluctuation in prices is a direct indication of risk. High-risk assets will show high fluctuation.

If the assets are held for sufficient length of time the fluctuations also even out and the long-term return from the assets will also reflect long-term average returns relative to the assets. It is therefore important to invest over long-term to even out the risks.

The author is head of knowledge management at Money Bee Institute Pvt Ltd., Nagpur. Money Bee is a corporate training firm associated with NIFM (Ministry of Finance, GoI), SEBI, NSE, BSE, SBI and leading mutual funds in India. He can be reached at ramkiraj@hotmail.com.

The assets with higher risk can possibly give us high return and assets with low risk characteristic may produce low returns. It is important to understand this relationship between returns and risk. It is important here to look at historical returns from particular type of assets to temper expectation. Another factor in making the choice of the investment vehicle is the risk-reward relation of the instrument and the length of time available for maturing of the goal.

While making the choice of investment we will look at the purpose, time available, the levels of inflation and the post tax return possibility from the investment. Further the choice will be influenced by the risk to reward relationship and the capacity or inclination to tolerate the risk. All these factors are required to be estimated based on historic trends and general outlook for the future.

Let us look at the case study of Ajit who has investments currently in equities including equity mutual fund, debt including debt mutual funds, PPF, post office/bank deposits, bank balance (CA/SB) having differing return perspective coinciding with differing risks as brought out in the earlier paragraph.

Now we will look at each of his goals and make an objective assessment of the choice of the investment vehicle. Let us take the first goal of providing for his children's education, which is likely to occur at the end of eight years from now with an inflation factor of 9 per cent per annum.

We had seen that if savings are commenced after two years with monthly amount of Rs 8,780 and invested in equities (70 per cent) and debt (30 per cent) with average return of 10.8 per cent per annum for a period of six years, the amount accumulated will in all probability be enough to fund the goals.

The reason for a choice of the instrument of equity 70 per cent and debt 30 per cent stems from the fact that the goal of education is a priority goal requiring that the investments to a large extent remain safe. Further as the goal is set after eight years Ajit has time on his hand to earn higher returns for a portion of his investment.

The mix has been suggested keeping in mind the inflationary impact expected of 9 per cent per annum requiring a post tax return exceeding 9 per cent. The fact that Ajit has other investments with no liabilities (net worth) currently of Rs 23 lakh gives him the cushion for directing his savings to equities, which we know has the highest level of risk (variability in returns).

The second goal is that of marriage expenses of his daughter estimated to cost Rs 6 lakh after 192 months given the general inflation of 6 per cent, the current cost of Rs 2,35,000. The monthly savings required for a period of eight years commencing eight years from now in equities and PPF in the ratio of 50 per cent each will require Rs 4000 assuming an average post tax yield of 10 per cent per annum.

The choice of PPF instead of debt is because it provides absolute safety with entry-level tax benefits in addition to a post tax return of 8 per cent. The 50 per cent equity is for increasing the wealth of the investments due to its potential for giving higher returns and also the time available for levelling out the risk.

In respect of goals of purchasing a car & providing for expenses towards annual tour we have directed the investment to the safest option of bank deposits as the goal is short-term where risk cannot be taken during the accumulation stage. Similarly we had assumed that the surplus above the investments for goals for the first five years will be directed towards investments in equity and the accumulated amount used for meeting partly the goal of purchasing a house.

The balance amount will be through a loan with repayment of Rs 16,200 every month from surplus. As the time available is five years, the savings has been directed to equities given the risk tolerance level of Ajit and the longer time frame to level out the risk.

The major goal of retirement will be funded from surplus after eight years from now after meeting the outgo of Rs 31,000 towards housing loan repayment, marriage expenses and annual tour. The surplus will be Rs 4,000 per month. This amount will be saved in equities (long-term goal) for a period of eight years commencing after eight years from now.

The investment will be raised to Rs 8,000 per month thereafter, as the goal of marriage will be over by then. The investment will continue for a further period of four years. The housing loan would have been fully repaid by then and Ajit will be 55 years old.

The investment will be continued for another three years in equities with enhanced contribution of Rs 24,200 per month. At Ajit's age of 58 it will be necessary to de-risk the investment and accordingly the corpus will be transferred to a debt fund and the monthly contribution of Rs 24,200 per month continued for another two years. This will enable Ajit to have a sum of Rs 44 lakh as retirement corpus.

We have looked at investments in broad categories in the above example and it will be necessary to further drill down to specific instruments in each category. Similarly the division ratio between the categories can also be fine-tuned.

In the next article we will be looking at achievement of the objectives and a holistic view of the plan.