Investment Planning

In the last blog we learnt about various investment classes. Now let’s explore what is Investment Planning. Investment plan is like your vacation itinerary where great deal of effort is taken to ensure maximum comfort and joy at optimum expenses.

But before we do that I would want you to know about a very important and integral part of investment planning - emergency fund. Emergency fund simply means an amount kept separately for unforeseen situations. This is a fall back fund to keep your investment process unaffected by the unforeseen incident. You can manage without emergency fund only if you have health insurance, motor insurance, personal accident insurance, home insurance, term insurance and a set of reliable good friends and relatives. But if you don’t, then please maintain an emergency fund of about 6 months of your monthly income. This can be kept as cash at home, in savings account or any other option where liquidity is high.

Now having said that let us start with the steps in investment planning. The investment options available are PPF, fixed deposits, postal deposits, recurring deposits, government bonds, tax free bonds, stocks, derivatives, gold, real estate, mutual funds. That is quite an exhaustive list to choose from. Following points should be considered before zeroing on the investment option:

Goal: If the WHY is clear the HOW becomes easy. So WHY are you investing? Are you investing for buying a home, for your child's education, for upgrading your car, for going on a world tour, for your post retirement life or just to create wealth? Every of the above goals can be linked with the time period to achieve the goal and the priority in your goal list. So someone would prioritize world tour over retirement or vice versa. Defining the goal and deciding the priority is completely dependent on YOU.

Target amount: Once the goal list is finalized, the next step is deciding the target amount. How much would each goal cost you? Let's say you want to buy a new car 3 years from now. A car of your choice worth Rs. 5 lakhs now would cost you more than Rs. 6.5 lakhs after 3 years.

So while deciding the target cost one ought to consider the effect of inflation. Inflation reduces the purchasing power of your money. Do not consider the Wholesale Price Index (WPI) or Consumer Price Index (CPI). WPI is based on the price prevailing in the wholesale markets or the price at which bulk transactions are made. The CPI is based on the final prices of goods at the retail level. But these inflation indicators should not be blindly considered in investment planning. Inflation rate should depend on the underlying expense. For example, the inflation rate of medical expenses is way higher than inflation rate of electronic goods. So inflation rate in your investment plan should depend on the nature of the goal and the underlying goods and services.

Post tax returns: I have deliberately used the term 'post tax'. People usually ignore the tax that will have to be paid on the returns earned on the investment. Returns on investments are classified based on nature of rate of return. If at the time of investment, the rate of return is known, the returns are classified as interest income. If the returns are unknown, they are classified as capital gains. As a thumb rule you can remember that tax rules favor capital gains over interest income. But there are exceptions too. Interest income from tax free bonds, PPF, PF is tax free.

You earn interest income from recurring deposits, company deposits and fixed deposits. Capital gains are earned from real estate, gold, stocks, derivatives, mutual funds. Even though the tax rules might change in the future, one should always choose investment options based on the post-tax returns.

Risk: We usually come across the statement – no risk no gain. In the investment world the word risk is usually related to the safety of the capital invested. So if the investment is risk free, as in case of a fixed deposit, there is an assurance that the capital won't erode and earns some returns. On the other hand in risky investments (or bets), like in case of equities, there is possibility that the capital will be eroded.

One should not think that risk is limited to investment options only. It is also a RISK when you fall short of the target amount of your goal. This might be due to the wrong choice of investments. You might have to let go off the goal or bridge the gap by borrowing. But all things cannot be funded by borrowed money. While you can fund your child’s education by an education loan, no one will lend you for your post retirement expenses.

There is one more facet to risk. What sugar intake is for a diabetic patient is risk for the investor. You might love to eat sweet things but your medical condition won't allow. Similarly you might love to take risk in your investments but your financial conditions won't allow you.

So choosing the right investment option with the right amount to be invested for the right period is an effective way to counter risk. At the end I bring the simplest known formula for you to remember. For goals with time frame up to 3 years go for debt options. For 3 to 7 years go for combination of debt and equity. And for goals farther than 7 years go for equity.

Happy planning and investing!

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VittaSiddhi