Whose Money is It Anyway?

Introduction to Personal Finance Tax-saving; from F/A! Circumstances Employee Chit-chat Call from relationship Manager Friendly neighbourhood insurance agent When does the typical, average, salaried individual start thinking about money, investing, personal finance?

Personal Finance Approaches Tax-savings first Buy products or make investments in haste at the end of each FY Product-first Seek out a product for a need without understanding/analyzing the need Returns-first Maniacal obsession over returns without paying heed to long-term and short-term risks

Personal Finance Approaches Needs first Thorough evaluation of needs … and wants! Product-last We do not search for products. We narrow down a type of product and then select one from that type Tax-planning incidental Select a product from the chosen category that saves tax.

Personal Finance Approaches Tax-savings first Product-first Returns-first Needs first Products-last Tax-planning incidental Goal-based investing

years

Goal-based investing List all known ‘needs’ and ‘wants’ Classify them in order of importance Classify them as per duration Analyze each need/want. Determine how much we need to invest Determine how much we can invest(!) Decide on an approach Find suitable investments Invest Monitor; Manage – A life long exercise!

First, we need to build a moat! Caerlaverock Castle, Scotland. Source: Wikipedia Wikipedia Random Ramblings

1. Protection against …. Death of breadwinner(s) 1.Inflation-proof income to manage monthly expenses at least until kids go to a job 2.School fees 3.College fees 4.Marriage expenses 5.Other liabilities Solution: Life Insurance Product: Pure Term Life Insurance until retirement

2. Protection against …. Hospitalization of family members 1.History of illness 2.Age of dependents 3.Typical room rents in neighboring hospitals 4.Exclusions 5.Pre-existing disease clause 6.Co-payment Solution: Medical Insurance Note: Enhance sum insured annually

3. Protection against …. Emergency expenditures 1. Monthly expenses x Medical emergencies 3.Liabilities Solution: Rainy day fund Products: SB account; Online FDs, Liquid funds. No credit cards! Key: Returns are irrelevant; Taxation is secondary; Ability to replenish

4. Protection against …. Disability 1.Must if job is not permanent 2.Must for professionals and businessmen Solution: Accident Insurance Products: Get from general insurer not from bank! Key: Read policy document before buying

5. Protection against …. Critical illness? 1.Complex products 2.Better off starting a corpus for medical expenses – treat as a long term goal Solution: CI insurance

6. Protection against …. Misuse (intentional or otherwise) An action plan and & a Will More to a will than, ‘who gets what?!’ It is a set of broad guidelines instructing a spouse or guardian about how to use the corpus accumulated for each long-term goal Best to identify a trustworthy professional

Interrupted compounding Danger: Lifestyle change during retirement Solution: Efficient goal planning 7. Protection against ….

Life, health, accident insurance etc Emergency fund Financial Goals

Retirement Life, health, accident insurance etc Emergency fund Other long-term goals

Cash Flow Analysis: Creating a Zero-based budget Zero-based budget: “One in which every dollar is assigned a role” – Dave Ramsey No money left at the end of the month! Live ‘hand to mouth’ because of investing! No lump sums allowed!

Zero-based budget Step 1: List all sources of income Step 2: List all monthly expenses Step 3: List all annual/recurring expenses Step 4: List present and future liabilities Step 5: List all present investments (incl EPF etc.) Step 6: Determine amount available for investment (incl EPF)

Recurring Expenses Insurance premium, school fee, AMC fee etc. Returns: irrelevant Taxation: Irrelevant Instruments: SB acct; RDs; Liquid funds; Arbitrage fund(?!) …

Future Expenses: aka financial goals! List all expected expenses in future Expenses before income stops Expenses after regular income stops aka ‘Retirement’

Dividing the goal timeline ~ 5 years Save Invest

Power of non-compounding Power of compounding does not matter for ~ 5Y or less

Saving vs. Investing ~ 5 years Saving Investing Choose not to Worry Inflation Returns Choose not to worry Importance of beating Inflation, grows with duration Importance grows With duration Taxation Choose not to worry Importance grows With duration

Short-term Goals: determining how much to invest What is the current Cost ?  Take all expenses into account  As accurately as possible Use an inflation of 8-10% (more for a safety margin) Return = post-tax interest rate of FD or RD Most people can pull this off

Years to goal5 Present cost5,00,000 Inflation10.0% Post-tax rate of return of portfolio6.00% Future Cost = x (1+10%) 5 8,05,255 Amt invested so far2,00,000 Post-tax rate of return on current investment6.00% Future value of curr. Inv. = x (1 + 6%) 5 2,67,645 Annual increase in monthly invest. % Initial monthly investment required7,498 Annual increase in monthly invest. %10.00% Initial monthly investment required6,209

Short-term Goals: selecting instruments Nature of taxation: 1)Tax upon maturity/redemption (debt mutual funds) with indexation. 2)Tax each financial year (RD/FD) as per slab

Why not have some equity exposure? Is not 5 years long-term?!

Year 1Year 2Year 3Year 4Year 5 10%

Year 1Year 2Year 3Year 4Year 5 10%9%8%7%6% Year 1Year 2Year 3Year 4Year 5 10%

Compounded Annual Growth Rate Year 1Year 2Year 3Year 4Year 5 10% Geometric Average

Year 1Year 2Year 3Year 4year 5CAGR 10% 10.00% Year 1Year 2Year 3Year 4year 5CAGR 25%7% 10.05% Year 1Year 2Year 3Year 4year 5CAGR -25%21% 9.96% Year 1Year 2Year 3Year 4year 5CAGR -25%7% -0.34% Illustration: Volatile Compounding Year 1Year 2Year 3Year 4year 5CAGR 25%-25%7% 2.81%

Liquid Mutual Funds Savings bank account linked to bond market Invests in short-term bonds (4- 91 days) Sensitivity to interest rate change: low Risk of default: low Least volatile asset class.

HDFC Liquid Fund

HDFC Liquid Fund Arithmetic average ~ 7% CAGR ~ 7% (12 year) Difference ~ 0.02%

Average Standard deviation ~ 2% Arithmetic average ~ 7%

HDFC Liquid Fund Expected return ~ average +/- stdev ~ 7% +/- 2% Value Research online: Standard deviation: 0.21%

Discrete Rolling Return Understand risks before investing

Continuous Rolling Return- 2Y 2048 Two year intervals bet April 3rd 2006 to Dec 4th 2014

Continuous Rolling Return- 2Y

JM Monthly Income Plan Fund Equity Exposure: 11% to 15% Cash-equivalent Exposure: 41% to 85% Rest Bonds

Arithmetic average ~ 5.68% CAGR ~ 5.50% (10 year) Difference ~ 0.18% Standard deviation : 6.25% JM Monthly Income Plan Fund

There is more to investing than returns! Standard deviation is the simplest measure that an investor can use to select investment categories. Standard deviation listed in fund portals like VR online, Money Control, Morning Star are of limited use Investors will have to calculate the stdev. for the investment duration in mind from annual returns Whose money is it anyway? There is more to investing than standard deviation too!

Intermediate-term financial goals 5-10 years Saving/Investing? Important Inflation Returns Important because inflation is important Taxation Important because inflation is important

Equity oriented balanced funds (> 65% equity) AMC suggests investment horizon 3-5 years vs. Debt oriented balanced funds (<20% equity) AMC suggests investment horizon 1-3 years

1 year rolling returns

3 year rolling returns

5 year rolling returns

7 year rolling returns

10 year rolling returns

Years to goal10 Present cost10,00,000 Inflation10.0% Post-tax portfolio rate of return6.00%8.00%10.00%12.00% Future Cost25,93,742 Annual increase in monthly invest. % Initial monthly investment required15,47013,81512,32910,997 Annual increase in monthly invest. %10.00% Initial monthly investment required10,1599,2058,3337,537 FD/RD 30% Equity 60% Equity I can only invest 6000 a month. What should I do?

Long-Term Goal Planning

Long-term financial goals Greater than 10 years Vital Inflation Returns Important because inflation is important Taxation Important because inflation is important

Inflation in India: Some Real Numbers Jan 1995 to May 2014

Permanent loss in capital

We need to be practical! We cannot expect more because we cannot invest enough!

Returns do not matter!