Most of you would wish to create substantial wealth over your working life and thereby spend a care-free retirement or meet some of your medium term financial goals.
To achieve that, you focus on increasing your earnings and reducing your expenses but what to do with the savings so that they grow manifold, is not something that comes naturally to you.
The savings would usually lie in a savings account or a fixed deposit or something similar. As the savings increases with time, you grow impatient to deploy them profitably for which you start looking for advice from people around or reading expert columns.
This is akin to curing your medical condition by reading doctor’s advice online. Managing money, like managing health, is based on sound processes and principles and should be conducted in line with these principles.
Setting of financial goals
The starting point is to arrive at your financial goals for short, medium and long term.
If, for instance, your short term goal is to finance your higher education (assume Rs.20lakhs is required in 3-years time), you would want to know the amount you need to save (say every month) for next three years in order to achieve the objective.
You would also want to know the amount that should be invested in different kind of investment avenues (say equity shares, bank deposits, etc) since some of them give higher returns but they also carry higher risk.
So for example if you invest an amount of Rs.44,000 per month in equity (assuming equity provide a 15% return per year), you would be able to meet your goal of receiving Rs.20 lakh at the end of third year.
However if you choose to invest only in bank deposits which provide a return of say 7% per year, then to receive Rs.20 lakhs at the end of third year you would need to invest about Rs.50,000 per month.
Bank FD is less risky than equity shares and so would offer lesser return and hence would require higher investment.
There is a third possible way by which you could distribute your savings between equity shares and Bank deposits. In this if you deploy Rs.22,165 in equity and about Rs. 25,000 in bank deposits every month (total per month investment of Rs. Rs.47,200), you can achieve your goal of Rs.20 lakhs at the end of three years.
This way you are able to meet the same goal by decreasing your contribution when compared to a case where all investment is made into bank deposits. In the above case the allocation between risky (equity shares) and less risky (bank deposits) is 47% and 53% of total savings for each month in three years.
However as the goal date approaches you would want to take less risk in terms of your investments. This can be achieved by reducing the proportion of investment in risky assets as the goal date approaches.
This is what is referred to as (decreasing) glide path model wherein you could start with higher proportion of investment in risky assets at the start and gradually reduce it as the time approaches the goal date.
Research shows that the allocation also depends on the return environment facing the investor. In a higher-return environment, increasing glide path appears to perform better while in lower-return environment the decreasing glide path model leads to higher returns.
So if the economic indicators show a likely upturn in the economy, the investor is better-off increasing the allocation to risky asset class. Thus it is important to have a view of the macro environment when applying to a model to maximize the returns. The glide path model, a term borrowed from airline industry, is based on the intuition that allocation to equity in a portfolio should equal 100 less your age. This was first used to manage retirement funds for investors.
In order to further reduce the risk, the investment in risky and less risky assets is made through the mutual fund route.
An equity/debt mutual fund invests in a basket of equity shares/debt thereby reducing the risk of the investment. Thus as said before, managing money is a process driven approach which should take into account the investor’s goals, risk-appetite and knowledge of markets and macro-environment in order to arrive at the optimal portfolio.