Take control of your financial journey: Part 2

In the first part of our blog post, Take control of your financial journey, we discussed why is it important to plan your financial journey just like you plan your travel. Without proper planning, you are likely to put your and your family’s financial future at risk. In the second part of this post, we will discuss certain aspects of financial planning and also observe the similarities with travel planning.

As discussed in the first part, choosing the travel destination is like selecting a goal in financial planning. How you reach your destination, where you stay and what you do there, are the most important factors that will define your travel experience. Similarly, in financial planning, the right saving and investment will determine whether you are successful in meeting your financial goal. Let us first discuss savings.

Importance of Savings in Financial Planning

In my view, saving is like the mode of travel (flight, train, bus, car etc.). The mode of travel is an essential component of travel. For example, if you have 5 day vacation and you take 3 days travelling to and from the destination, then you are left with just two days in the destination. There is the cost angle as well; some modes are travel are more expensive than others (flights in our country are certainly more expensive than trains). So your budget is one of the most important factors in deciding how to travel. A limited budget does not necessarily mean limited fun. When I was a kid, long distance travel was almost always in trains because my parents could not afford airfare. Train journey has its own romance. Also when we were travelling by train, my parents also ensured that, apart from the time spent on the train, we spent enough time in the destination as well; so long distance travels were planned only we had long holidays. This meant travelling only once in a year or once every two years, but we used to have a lot of fun travelling.

Similarly, just because you have limited savings at the start of your career, it does not mean that you cannot start financial planning. Start by investing whatever you can save, be patient and over a long investment horizon you will be rewarded. When you have more savings, you can invest more and start planning for multiple financial goals. It is like flying to a destination; you save a lot of time and so you can plan to do much more in limited time. Different people have different savings capacities, depending on their incomes and expenses. If you think of your financial goal as a final product, then savings are the most basic raw materials. The final product (goal) depends on the raw materials (savings) and the value addition (investment). Therefore, your goal expectations should depend on how much you can save.

Investments in Financial Planning

The next part of travel planning is lodging. There are a variety of lodging options available for different travel destinations. Choosing the perfect lodging option during travel planning is often confusing because there are different options which can make decision making that much harder. For my family, there are various considerations in choosing where we stay. If I am travelling with my entire family (wife, child, parents etc) we would choose a lodging option which is convenient for everyone; for example, we would choose a hotel, which is easy to reach, has all the amenities and is well connected to emergency facilities (e.g. hospital). If am travelling with a group of friends, we would select a lodging option which caters to the need of the entire group, probably a resort which has sufficient rooms to accommodate the entire group and offers different recreational facilities. If it is just me and wife travelling, we prefer privacy and some of the other factors are not that important; my wife likes the experience of home stays when just the two of us travel together because she feels that, we get a more intimate experience of the place during home stays and she gets to make friends with another family.

Making an investment decision is a lot like choosing a lodging option when travelling. We often get queries in Advisorkhoj.com asking our suggestions on the “best equity funds” or “best mutual funds”. There is no such thing as the “best mutual fund” or “best equity fund” or “best debt fund”; you should select a fund which meets your requirement. In the previous paragraph, I discussed that, I choose a lodging option based on my needs when I am travelling. Some of the factors involved the right lodging option are cost, co-travellers, length of travel, the kind of travel experience we are looking for etc. Similarly, the choice of the right investments for you depends on several factors:-

• Goal or objective – Is your goal, capital appreciation or income?


• Goal timeline – Is your goal short term, medium term or long term? Is your goal timeline rigid or somewhat flexible?
  
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• What is your risk capacity – Some investors think that, risk capacity is defined by how much money you are prepared to lose. It is a wrong way to think about risk capacity because no investor wants to lose money. You should think of risk capacity as how much unaffected will you be in terms of meeting your debt obligations and meeting your day to day needs, in case of any temporary adverse impact on your investment due to market risks. Risk capacity differs from investor to investor, but generally speaking, if you have regular income source (apart from investments), have low or no debt and a long goal timeline, then your risk capacity should be high.


• What is your risk appetite – Many investors confuse risk capacity with risk appetite. Risk capacity is dependent on your financial situation, whereas risk appetite is subjective and depends on your investment temperament. If you get stressed by short term volatility then your risk appetite is low, whereas if you are not stressed by short term volatility then your risk appetite is high.


• Your tax situation – Different investment products have different tax treatments. While you should never make investment decisions purely based on tax considerations, your tax situation can be an important secondary factor in your investment decisions.
  
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Different investment products have different risk / return profiles

Just like different lodging options offers different travel experiences, different investment products have different risk / return profile. Many a times, we get queries in Advisorkhoj.com like, “how can I get at least 25% annual returns with moderately low risk?” It is like asking “how can I get Five Star experience by staying in a budget hotel?” The answer to both the questions is that, it is not possible. If someone tells you it is possible, then that person is either ill-informed or is trying to deliberately mislead you. We have seen so many people in our country falling victims to Ponzi schemes which offer high assured returns; many investors have lost their life’s savings due to these fraudulent schemes.

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Investors should understand that, risk and return are directly related. Mutual fund investments are subject to market risks, but the effect of market risk smoothens out (lessens) over a long investment horizon. Therefore, your risk of losing your capital (due to market risks) is lowered if you have a long investment horizon. If you understand the relationship between risk, return and investment horizon, then you will be able to make the right investment decisions.

Equity funds have the highest investment risk, but they can give the highest returns in the long term. Within equity funds, midcap funds are more risky than large cap funds, but midcap funds have historically given higher returns than large cap funds; however, you need to have a longer investment horizon for midcap funds to get the best results. Capital appreciation is the investment objective in equity funds.

Debt funds have lower investment risks compared to equity funds; obviously, the returns are also lower. Within debt funds, different debt fund product categories are subject to different levels of risk (interest rate risk). Liquid and ultra-short term debt funds have very little interest rate risk, short term debt funds have limited interest rate risk, while long term debt funds are sensitive to interest rate risks and can be volatile when interest rate changes. Income is the primary investment objective in debt funds.

Did you know how to select debt funds

Hybrid funds invest in both debt and equity. These funds combine the risk / return characteristics of both equity and debt funds. Their investment objective is both income and capital appreciation; however, the relative importance of income versus capital appreciation in hybrid funds depends on the asset allocation (debt to equity mix) profiles of these funds. Some hybrid funds (e.g. balanced funds) have a high allocation to equities, more than 65%; these funds can give good returns through capital appreciation in the long term, while limiting downside risks in the short term. Debt oriented hybrid funds (like Monthly Income Plans) have a high allocation to debt, from 75 – 95%. Income is the primary objective of these funds, but the equity component of these funds can give a kicker to returns and help investors beat inflation in the long run.

You may like to read all about hybrid Mutual funds

Different types of funds have different tax treatments

The minimum holding period for long term capital gains in equity funds is one year. Short term capital gains (if the units are sold before one year) in equity funds are taxed at the rate of 15% plus 3% cess. Long term capital gains tax in equity funds is zero. Dividends paid by equity mutual funds are totally tax free. Equity funds are much more tax friendly than asset classes like gold and real estate.

The minimum holding period for short term capital gains in debt funds is three years. Short term capital gains (if the units are sold before three years) in debt funds are taxed as per applicable tax rate of the investor. Long term capital gains (investment tenure of more than 3 years) of debt fund are taxed at 20% with indexation. Indexation benefits reduce the tax obligation of debt fund investor considerably compared to say investments in bank FDs and many small savings schemes.

For investment tenures of over three years, debt mutual funds are definitely much more tax friendly than bank FDs and post office small savings schemes. While dividends are tax free in the hands of the investor, the fund house pays dividend distribution tax (DDT) for debt funds before distributing dividends to investors. For Resident Indians and HUFs, the Dividend Distribution Tax paid by non equity fund schemes is 25% + 12% surcharge + 3% cess = 28.84%.

Conclusion

Many aspects of travel planning depend on how much we can afford and the kind of experience we want. Financial planning is also a lot like travel planning in that respect. Each one of us has different needs and financial situations; you need to make your investment decisions based on your needs and financial situation. In this blog post, we discussed, the various factors involved in investment decision making. Empowered with knowledge, hopefully, you will be able to make better investment decisions in the future.