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

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.College fees 4.Typical room rents in neighboring hospitals Solution: Medical Insurance Note: Enhance premium 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

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 present investments (incl EPF) 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

Short-term Goals: selecting instruments Focus on nature of taxation: 1)Tax upon maturity/redemption (mutual funds) 2)Tax each financial year (RD/FD) 3)As per slab; with indexation; flat rate; Prefer: Tax upon redemption with indexation (debt mutual funds)

Note on indexation benefit Capital gains = Sale Price – Purchase price If the purchase was made 3Y ago, Inflate purchase price using cost inflation index (Sale Price – Inflated Purchase Price) Can be negative long-term capital losses can be set off against long-term capital gains

Short term capital loss (both in equity or debt fund) short term capital gain (equity or debt funds) long term capital gain (debt funds) long term capital loss (debt funds) long term capital gains (debt) long term capital gains in equity mutual funds are tax exempt … for now! Source: CafeMutualCafeMutual Offset against

Why not have some equity exposure? Is not 5 years long-term?! A primer on volatility Year 1Year 2Year 3Year 4Year 5 10% Annual Returns

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

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

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% Morning Star: Standard deviation: 0.26% (0.48%)  3Y 0.6% (0.95%)  5Y 0.55% (0.91%)  10Y

Rolling average Why bother? Choose FD/RD and move on to better things!

JM Monthly Income Plan Fund Equity Exposure: 11.5% to 15.1% Cash Exposure: 41% to 85% Rest Bonds

Arithmetic average ~ 5.68% CAGR ~ 5.50% (10 year) Difference ~ 0.18% Standard deviation : 6.25%

%8.54%10.86%11.54%-9.44%8.53%4.14%2.67%11.25%4.57% 4.83% 5.70% 4.82% 3.23% 3.17% 6.19% Rolling average JM Monthly Income Plan Fund

Canara Robeco Monthly Income fund Arithmetic average ~ 11.7% CAGR ~ 11.24% (12 year) Difference ~ 0.47% Standard deviation : 10.4%

Rolling average % 15.30% 9.34% 13.99% 12.59% 9.17% 7.46% 11.47% Canara Robeco Monthly Income 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 return is important

Return Expectations vs. Equity Exposure

Liquid Fund: 100% Large Cap Fund: 0%

Liquid Fund: 90% Large Cap Fund: 10%

Liquid Fund: 80% Large Cap Fund: 20%

Liquid Fund: 70% Large Cap Fund: 30%

Liquid Fund: 60% Large Cap Fund: 40%

Liquid Fund: 50% Large Cap Fund: 50%

Liquid Fund: 30% Large Cap Fund: 70%