One of the most important factors to consider while drawing a financial plan is fixing the time period, especially if you are a beginner.
The thumb rule is, the earlier you start, the greater the chance of achieving your financial goals.
Further, an early start significantly reduces the investment amount required to meet those goals. For example, Rs 1,555 invested every month from the age of 25 would yield Rs 1 crore at 60 - assuming an annual return of 12% (Chart 1). Alternatively, if you start investing at 30, the required monthly investment would be Rs 2,861, and Rs 5,322 if you start at 35. Moreover, as you age, an increase in family responsibilities or an individual’s health would start chipping away the investible surplus.
*Assuming a 12% return on investment per annum
The magic of compounding
Yes, compounding is magical. Albert Einstein, the great physicist, said it is the eighth wonder of the world. "He who understands it, earns it… he who doesn’t, pays it." He also called it the most powerful force in the universe. He could understand the magic of compounding, because he understand the value and importance of time, which plays a very pivotal role in the world of finance.
The biggest benefit of investing early (i.e., when time, earning capability and health are on your side) is compounding. In simple terms, an investment along with returns on it reinvested together deliver more over longer period than what a simple interest would. Besides the power of compounding, early investing instills discipline in spending and helps to achieve near-term and long-term goals. Who wouldn’t love to retire at 40s?
Chart 2: Effect of power of compounding on a sum of Rs 1 lakh across time frames
Investing according to financial goals
Before investing in any financial product, the first thing you should ask is what you are investing for – is the goal compelling enough to forego the pleasure of spending the money today? This will provide clarity and help you choose the investment products best suited to your needs and investment horizon.
The goal-based approach involves investing to achieve specific goals at different stages of one’s life by allocating money to different asset classes, in sync with your risk capacity and time horizon. This does not result in over-exposure or under-exposure to any specific asset class.
Steps to goal-based investing
1) Identify and prioritise goals:
The first step in goal based investing is identifying and prioritising goals by segregating them into needs and wants – needs are essentials and hence get precedence over wants, which are desires and aspirations. Once decided, align your needs/wants to the time horizon.
2) Evaluate the future value of each goal:
Inflation erodes the purchasing power over a period. For instance, assuming that the current cost of higher education is Rs 10 lakh and annual inflation on education is 10%, a person would require Rs 26 lakh for his/her child’s higher education after 10 years.
3) Assess the risk profile:
Determining the risk appetite
of an investor is essential for making asset-allocation decisions. Risk profiling helps one to assess the risk-bearing capacity. According to the risk-taking ability, investors can be broadly classified into five profiles – conservative, moderately conservative, moderate, moderately aggressive and aggressive. Generally, essential short-term goals should have a conservative portfolio. Essential long-term goals should have moderately aggressive portfolio and long-term non-essential goals should have a more aggressive portfolio
4) Asset allocation:
The most important factor to be kept in mind while allocating assets is diversification. One should build a diversified portfolio by allocating money to different assets according to their risk profiles (Chart 3). Short-term goals (child-care expenses and down-payment for home) would require conservative asset allocation (debt), while medium-term goals (children education and old-age parent care) and long-term goals (retirement and children’s marriage) would require moderate and aggressive asset allocation (mostly equities).
Chart 3: Sample asset allocation
For every goal, there is a mutual fund
Investors can opt for mutual funds to attain all such needs across different life stages. For instance, investors with higher risk appetite and long-term goals can look into equity mutual funds for better wealth creation. Similarly, for short- to medium-term goals, there are mutual funds ranging from liquid funds (an alternative to savings account) to debt mutual funds and hybrid mutual funds. Further, debt mutual funds are also tax-efficient than fixed deposits, due to indexation (adjusting returns for inflation).
Tax Planning – An integrated part of investments
Often investors consider tax planning as a last-minute exercise towards the end of a financial year. They scramble for available tax-saving instruments in a hurry and mostly end up locking their money in possibly an instrument which does not match their investment objectives. Tax planning should ideally be a disciplined part of year-round investments and should be started at an early age. Don’t just stick to traditional avenues; while they are safe, they may not be able to beat inflation. Mutual funds soothe the tax pain via equity-linked savings schemes (ELSS
) and Rajiv Gandhi Equity Savings Scheme (RGESS). RGESS provides tax benefits under Section 80CCG for the first-time equity investors and ELSS, which predominantly invest in a diversified portfolio of stocks and have a lock-in of three years, provide benefit under Section 80C for investments made up to Rs 1.5 lakh per financial year.
Explore the systematic method of investing in mutual funds
Investors can also benefit from the systematic plans offered by the mutual funds. For instance, a systematic-investment plan (SIP) is used for wealth accumulation. A systematic-transfer plan (STP) helps in transferring wealth from one asset to another, in safeguarding the portfolio against volatility, and in adapting to the changing risk appetite with age and increase in responsibilities. Lastly, a systematic-withdrawal plan (SWP) is useful in deriving a regular income from the created wealth created.
Reviewing and rebalancing
As markets are volatile, regular fine-tuning of a portfolio is crucial. Adjustments in asset classes should be made in line with the market movement to reap maximum benefit. Further, the preference for asset classes varies across various stages of life, based on the risk-return profile. For instance, to save for retirement, one should have higher allocation to equity in his early age, but gradually move toward debt, as he/she nears retirement. Reviewing also helps to weed out underperformers.
Long-term financial planning should include tax and retirement planning along with investment objectives. For this, investors should look at various mutual funds for excellent options at various stages of financial planning.
Any information contained in this article is only for informational purpose and does not constitute advice or offer to sell/purchase units of the schemes of SBI Mutual Fund. Information and content herein has been provided by CRISIL Research, a Division of CRISIL Limited, and is to be read from an investment awareness and education perspective only. The views / content expressed herein do not constitute the opinions of SBI Mutual Fund or recommendation of any course of action to be followed by the reader. Investors should consult their financial advisers before taking any investment decision.
Mutual Fund investments are subject to market risks, read all scheme related document carefully.