Financal Planning Comprehensive Guide

FINANCIAL PLANNING Simple hai!! Its not rocket science Fortunately, it isn’t as complicated as building up a spaceship; Unfortunately, there aren’t any fixed laws!!

Narender krishnani, CFA [email protected]

FINANCIAL PLANNING

To the victims of inflation, laziness & carelessness

Narender Krishnani, CFA

Email: [email protected]

FINANCIAL PLANNING

Contents INTRODUCTION ............................................................................................................................................... 1 BASICS OF FINANCIAL LITERACY ....................................................................................................................... 2 INFLATION ............................................................................................................................................................. 2 Types of inflation indices ................................................................................................................................ 2 Role of RBI ...................................................................................................................................................... 3 Impact on personal finance ............................................................................................................................ 3 INTEREST RATE ........................................................................................................................................................ 4 Policy rate ...................................................................................................................................................... 4 G-secs yields ................................................................................................................................................... 4 Nominal and Real interest rates .................................................................................................................... 5 Impact on personal finance ............................................................................................................................ 5 EFFECT OF TAXATION................................................................................................................................................ 6 ASSET CLASSES AND HISTORICAL RETURN ...................................................................................................................... 7 RISK MANAGEMENT ............................................................................................................................................... 10 RANDOM BRAIN DROPPINGS ........................................................................................................................ 12 BUYER BEWARE..................................................................................................................................................... 12 COMPOUNDING .................................................................................................................................................... 12 PENNY PINCHERS ................................................................................................................................................... 14 PERSONAL FINANCE- HYGIENE FACTORS........................................................................................................ 15 KEEP IT SIMPLE ..................................................................................................................................................... 15 INFORMATION MANAGEMENT.................................................................................................................................. 15 SENSE OF NETWORTH & TRACKER ............................................................................................................................. 16 KNOW THYSELF .............................................................................................................................................. 17 FINANCIAL OBJECTIVE ............................................................................................................................................. 17 CASH FLOW ASSESSMENT & SAVINGS RATE ................................................................................................................. 18 RISK APPETITE....................................................................................................................................................... 18 STITCHING IT ALL TOGETHER .................................................................................................................................... 19 LIQUIDITY AND CASH FLOW MANAGEMENT .................................................................................................. 20 LIQUIDITY ............................................................................................................................................................ 20 CASH FLOW PLANNING ........................................................................................................................................... 20 ASSET ALLOCATION & FUND SELECTION ........................................................................................................ 22 ASSET ALLOCATION ................................................................................................................................................ 22 Asset allocation strategies ........................................................................................................................... 22 Portfolio rebalancing ................................................................................................................................... 23 What constitutes portfolio ........................................................................................................................... 23 INVESTING IN EQUITIES ........................................................................................................................................... 24

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FINANCIAL PLANNING Products for investing in equities ................................................................................................................. 24 Splitting your equity pool ............................................................................................................................. 25 INVESTING IN FIXED INCOME SECURITIES ..................................................................................................................... 26 Taxation across debt instruments ................................................................................................................ 26 Credit risk and interest rate risk ................................................................................................................... 26 Splitting your fixed income pool ................................................................................................................... 28 SELECTING MUTUAL FUNDS ..................................................................................................................................... 28 Generic gyan ................................................................................................................................................ 28 Fund specific factors..................................................................................................................................... 29 NATIONAL PENSION SCHEME ................................................................................................................................... 29 Benefits ........................................................................................................................................................ 29 Drawbacks ................................................................................................................................................... 30 REAL ESTATE- HOME SWEET HOME ............................................................................................................... 31 PERSONAL RISK MANAGEMENT..................................................................................................................... 33 LIFE INSURANCE .................................................................................................................................................... 33 HEALTH INSURANCE ............................................................................................................................................... 35 CHECK-LIST .................................................................................................................................................... 36 ABOUT MYSELF .............................................................................................................................................. 38

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Introduction

Introduction These notes (although a fancy word for set of scribbled thoughts) originated as an exercise for self, to understand and effectively plan my own personal finance. What followed was a thought to structure it, so that a wider set of people could benefit from it. This is not: 

A textbook on financial topics, thus it presents a very basic and naïve version of some of the subjects discussed in pages to follow;



A recommendation on financial products, for which you should consult your own financial advisor;



An advice on tax efficiency of various financial products, for which you should consult your tax advisor;



A representation of thoughts of anyone else, apart from my own; be it the Company I work for (or worked in past) or professional bodies I might be associated with.

My intention here is not to guide you on how best to manage your finances, for which you are the best person yourself. But to expose you to the many angles of personal finance, so that you can actively start thinking about it and plan your journey on the road to financial well being. I have kept the notes fairly brief and in simple language. As a reader, do not try to digest this content overnight, but rather slowly, googling your way on different topics discussed and structuring your own thoughts on personal finance. Although, I have taken due care for accuracy of data and content, I do not assume any responsibility arising from any errors. Do not rely on this work, in whatsoever form, for taking any financial decision and consult your financial advisor. I am not a SEBI registered Investment Advisor. Treat this work as an academic exercise into the subject of personal finance. Also, I have tried to avoid references to any names/ companies in this note, but wherever it appears, I have not benefited by way of consideration in any form. Also, I intend to (no commitment) widen this work over time, to make it more comprehensive, basis the feedback I receive from you all, so please do write back with your suggestions/ comments or thoughts at [email protected]. Even a simple thanks is much appreciated!! Whenever I update this work, I will upload a copy on the website http://financialplanningsimplehai.com (under construction, just like my own financial plan). Hope it is worth your reading time.

Narender Krishnani, CFA [email protected] December 2018

Narender Krishnani, CFA

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Basics of financial literacy

Basics of financial literacy Reason to start-off with this section is that conceptual understanding of some basic financial topics is necessary, to effectively plan your finance and ask right set of questions to your advisors. This section covers in very brief, some financial topics, none of which are simple enough to be summarized in a page or two. So, if you want to read and understand more on any topic, you are just a google away. Further, the section is limited to very few topics of finance, that I though impact the most when it comes to personal finance.

Inflation This concept is understood in some form by everyone, from a layman to economists. Most commonly referred to as ‘Mehengayi’ in Hindi news media and a driving factor for many an elections. Very simply it refers to increase in prices of goods and services, calculated in percentage terms Year on Year (i.e. prices in month of this year vs prices in same month, previous year). Types of inflation indices Now one may ask, what is meant by increase in prices? Is it price of wheat or price of petrol or price of steel? Inflation at country level is mapped and measured as a basket of goods and there are separate indices for different objectives. Government of India (or ‘GOI’) publishes two common measures of inflation WPI and CPI. These indices are revised every few years to reflect changes in consumption basket and may also include revision in terms of calculation methodology. WPI or Wholesale Price Index: Measures average price changes of goods at the wholesale market level, where wholesale refers to ex-factory or mandi price. The new series (latest revision) came in effect from April 2017 and provides back dated calculation until April 2012, for research and analysis. WPI comprises of 697 items, split under three broad divisions: 

Primary articles (food, non-food and minerals): 22.6% of the weight



Fuel and power (coal, mineral oils and electricity etc.): 13.2% of the weight



Manufactured products (food products, textiles, metals, plastics, machinery etc.): 64.2% of the weight

WPI concerns more to the manufacturers and not the common man like you and me, as this reflects changes in price of commodity at the wholesale or bulk level. CPI or Consumer Price Index: Measures price change of goods at retail market level i.e. the price experienced by mango people (aam aadmi), when we go out and buy something from market. While we all are mango people, some mangoes are different from other mangoes and therefore CPI has two sub-groups to measure inflation for the two different set of consumers (urban and rural). CPI Rural has 53.5% weight in combined CPI index, while CPI Urban has remaining 46.5% weight. Below table summarizes, different weights accorded to each major category: Description Food & Beverages Pan, tobacco & intoxicants Clothing & footwear Housing Fuel & light Miscellaneous Total

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CPI Rural 54.2% 3.3% 7.4% 0% (no typo) 7.9% 27.3% 100.0%

CPI Urban 36.3% 1.4% 5.6% 21.7% 5.6% 29.5% 100.0%

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CPI Combined 45.9% 2.4% 6.5% 10.1% 6.8% 28.3% 100.0%

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Basics of financial literacy

Historical monthly WPI & CPI

160

10.0% 8.0%

150 6.0%

Inflation Index

140

4.0% 2.0%

130 0.0% 120

-2.0% -4.0%

110 -6.0% 100 Jan-13

-8.0% Jan-14

CPI Combined

Jan-15

WPI- All commodities

Jan-16

Jan-17

% CPI Change (YoY)- RHS

Jan-18 % WPI Change (YoY)- RHS

Above chart reflects CPI and WPI index, and percentage change YoY. Source: RBI As you might have noted, there is a big difference between urban and rural index on two items, food & beverages and housing; representing different expenditure pattern and thus the inflationary impact witnessed by each group. Similarly, inflation actually experienced by you as an individual would always be different from the headline numbers due to geography and different consumption pattern compared to index weights. While it may appear that inflation is bad, a small number is not so. Rather it is a by product of growth in economy. As your economy grows, so does the income of people, resulting in increased demand for goods and services and higher prices. The thing that hurts is high inflation. Relating to the concept of inflation is hyperinflation (very high price increase) and deflation (decrease in prices); not very relevant from the perspective of macro-economic scenario, we are in today. Google it, if you wish to understand it more. Role of RBI Inflation is monitored by RBI, particularly Monetary Policy Committee (or MPC), which comprises of three RBI members including Governor and three members nominated by GOI. MPC has been mandated to target the inflation (CPI) at 4% level with tolerance of 2% points on either side, basically 4% +/- 2% or 2% to 6% band. MPC is a new concept, implemented during August 2016 and the inflation target is mandated to the MPC until 31 March 2021. MPC has monetary policy tools at their disposal and an archetypical way of managing inflation is through interest rates. When inflation is expected to be high, interest rates are increased. This makes borrowing expensive, resulting in lower borrowing and thus reduced money supply (i.e. the amount of money in circulation) to be spent on goods and services, resulting in decreased demand and thus reduced increase in prices. Similarly, with lower expected inflation, reducing the interest rates will result in increased borrowing, thus increased money supply and therefore increased demand, resulting in increased prices. Impact on personal finance The key thing to understand from personal finance perspective is, if your money is sleeping and not earning equivalent of inflation, you are losing out. The amount of goods and services you will be able

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Basics of financial literacy to buy in two years time would be less than what you can now, despite the fact that notionally your money might have increased from 100 to 110 in two years. Eventually, we do not consume financial numbers, but pizza and cars, rum and cigarettes, clothes and housing, education and health; and the list goes on. And to be better off tomorrow versus today, the money needs to work and earn more than inflation.

Interest rate The world is infatuated with interest rates! If you consume financial media, you will note this as a recurring theme with coverage on RBI’s Repo rate, US Fed Fund Rate, yield on Government securities, yield on commercial papers, Marginal Cost of Lending Rate (or MCLR), home loan rates etc. etc. And the infatuation is fare as well. Interest rates impact a wide variety of economic participants because in some way, every body deals with debt. From Government to companies to individuals, everyone borrows or lends money; and usually both. You might have borrowed money for education loan or home loan, but at the same time will have some savings in FD or PF. Thus both your assets and liabilities are impacted by changing interest rates. Banks stands as intermediaries in this business; borrowing from one and lending to another. Parallel to banks are debt capital markets, a market place for institutions, where one can borrow and other lend, usually using standard form of debt (like commercial paper or Non Convertible Debentures etc.). Standing above all, is the big Daddy, and every country has got one called the Central Bank. For India that is RBI, acting as a gatekeeper of India’s financial system. Whoever you are, whatever you do, your life is in some ways impacted by interest rates. Policy rate It is a key lending rate of a Country’s Central Bank, which it uses to influence variety of monetary factors including inflation. ‘Policy Rate’ is the rate at which Central Bank lends to banks; banks being intermediaries in financial system, account for this change in interest rate to price or reprice their products to customers. This is how change in policy rates alter short term interest rates in economy. This is a very simple representation of functioning and flow of rates; and below link is the place to go for further understanding. https://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/DGVVAS34AEAD82174B44EA854710B1103E0988.PDF

For India, policy rate is overnight LAF (Liquidity Adjustment Facility) repo rate, set by MPC. This is the rate at which Bank’s can borrow from Central Bank on an overnight basis under LAF. In addition to the policy rate, Central Bank lends on other rates as well to banks and banks can also park additional cash with Central Bank; but all these different rates are correlated to the policy rate. This policy rate is what is mostly covered in financial media during every MPC meeting. G-secs yields Government securities refer to the debt issued by Government of a country. It comes in wide variety, including different maturities from few weeks to few decades, interest rates (fixed or floating) and currency (for info, most of GoI debt is denominated in INR). Usually, large institutional investors are the active participants in sovereign bond market (think of Banks, mutual funds, pension funds etc.). G-secs are practically considered to be default risk free, therefore safest option from credit risk perspective. Of the many securities issued by GoI, FIMMDA (Fixed Income Money Market and Derivatives Association of India) declares from time to time one bond as a Benchmark Bond. The Benchmark Bond has remaining maturity of 10 years. This Benchmark Bond’s yield (for now think of it as interest) is used across various indices, linked to derivatives product traded on exchanges and is also theoretically used in implied value calculation of equities. Yield on this Benchmark Bond is what is normally shown in financial media, when referring to 10 year sovereign yield.

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Basics of financial literacy Nominal and Real interest rates Whether it is government borrowing money or a company or bank in form of FDs, they always pay you interest on debt to compensate you for extending that loan. Theoretically this interest is a compensation for two components, inflation and ‘real’ interest over and above inflation. So let’s say you make a 100 Rs FD with a Bank for one year at 10% interest rate. One year later, bank repays you Rs 110. From our discussion on inflation earlier, you know, purchasing power of this 110 Rs would be different from initial 100 Rs, due to inflation. If inflation was 15% during the year, this 110 Rs is in real terms less than the initial 100 Rs. If inflation was 5%, this 110 Rs is slightly more than the initial 100. Nominal interest rate: in the above example, 10% interest was nominal interest rate. Interest rate that is normally quoted on loans or debt or FD or PF. Real interest rate: is the interest you earn, after removing the impact of inflation from the nominal interest rate. That is the actual (Real) earning a lender earns on a loan. In above example, for 5% inflation, real rate was 4.8% and in case of 15% inflation, real rate was negative 4.3%, i.e. real worth of your 110 Rs at the end of one year was 4.3% less than the initial 100 Rs a year before. Assuming, you paid 30% tax on your nominal interest income; the real after tax earning in 5% inflation case was just 1.9% and in 15% inflation scenario was a negative 7.0%. The formula for nominal rate, real rate and inflation is below: (1 + INR) = (1 + IRR)* (1+ Inflation) The above can be simplified by compromising on some accuracy to: IRR = INR - Inflation

Annual Nominal and Real rates (FY13-FY18) 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0%

FY13

FY14

FY15

FY16

FY17

FY18

CPI annual inflation %

Term deposit Rate (>5 Years)

Derived real rate

Derived after tax (@30%) real rate

Source: RBI & calculations Impact on personal finance From investment perspective, when you invest in debt, what matters is real after tax interest rate that you earn. This will impact your original capital and your spending capacity in future. When thinking in terms of investments, always think in terms of real interest rates that you will receive and that too after tax!! From the above chart, you will note that pre-tax real rates were negative in FY13 and FY14, i.e. even before taxes, you lost to inflation in actual spending capacity. Assuming a 30% tax on nominal interest (not far-off for people in 30% tax bracket), the real after tax return were negative till FY16 and was just 1.3% in FY18.

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Basics of financial literacy

Effect of taxation Drill it down in your head, what matters is after tax returns and always always think of your return on post-tax basis, whether it is equity or debt or any other asset class. For discussion purposes, I have considered three simplified taxation scenarios for returns generated on investment. So, when analysing the three scenarios, the common starting point is post tax principal of 100 Rs i.e. no benefit of tax exemption on principal was considered, which is the case with few investment products. The actual taxation regime is certainly more complex with lots of clauses. Also, some part below gets a bit mathematical, but in terms of calculation, could be easily done in Microsoft Excel. 

Exempt scenarios: When the income on investment is not taxed. Neither during each year nor during withdrawal. Typical example of this includes Provident funds & NPS. On equities, this was the case for long term capital gains till FY18. Future Value = Principal *(1+R)^N Where R is the interest earned N is the time period i.e. number of years



Accrual taxes: This scenario is applicable when the interest or income earned is taxed annually, irrespective of whether you withdrew the money or not. Most prominent example of this is FDs or interest earned in savings account; where the tax on income is payable every year. Future Value = Principal *(1+R*(1-T))^N Where R is the interest earned T is Tax percentage N is the time period i.e. number of years



Deferred capital gains taxes: This refers to scenarios where taxes are applicable when the money is withdrawn i.e. the investment realized. Common example of this is debt mutual funds, where taxes are payable when you sell the mutual fund units. On equity side, this is now the case after implementation of long term capital gains tax. Future Value = Principal *[(1+R)^N * (1-T) + T] Where R is the interest earned T is Tax percentage N is the time period i.e. number of years

Post tax value of investment

Value of Investment

2,000 1,600 1,200 800 400 0

5 Exempt

10

15

Years

Accrual Taxation

20

25

30

Defered Capital Gain Tax

The above chart shows, the value of INR 100 invested at 10% return and taxed at 30%, under the three taxation regimes! The lowest post tax returns are generated under accrual taxation, while the best return is obviously under exempt scenario. Deferred capital scenario is somewhere in between. As

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Basics of financial literacy time passes by, the difference under three scenario keeps on increasing. Therefore, when thinking of long term investment plans, it is very important to think from post tax basis, which includes understanding the impact of different kind of taxation.

Asset classes and historical return While the term asset classes might seem intimidating, you might already have a fairly good understanding of it. If I ask you, where can you put your money into eventual asset and not a conduit like mutual funds or ULIPS, the likely answers will be: 

Share market- an asset class, referred to as ‘Equities’



FD or Bond market- referred to as ‘Fixed income’

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Land or flat- broadly defined as ‘Real estate’

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Cash- Keep it as cash, referred to as ‘Cash & equivalents’, & includes money market instruments

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Gold- counted amongst wider ‘commodities’; although not considered a primary asset class

Each of these asset class represents a combination of securities; and some could be fairly different and at extreme ends to another. But at a generic level, securities within an asset class have similar risk-return characteristics, and different from securities in another asset class. As an example, high inflation hurts bond prices (cause your nominal interest is fixed) but is beneficial to real estate prices (driven by increase in costs, resulting in increased prices). Below are some charts, reflecting historical returns generated by different asset class.

Indexed returns across asset class FY80=100 30,000 25,000 20,000 15,000 10,000 5,000 0 FY80 FY82 FY84 FY86 FY88 FY90 FY92 FY94 FY96 FY98 FY00 FY02 FY04 FY06 FY08 FY10 FY12 FY14 FY16 FY18

Gold INR

Gold $/Oz

BSE Sensex

BSE-100

Term Deposit- 5Y

Source: RBI; BSE-100, FY84= 100

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Basics of financial literacy

YoY return across asset classes 100% 80% 60% 40% 20% 0%

FY81

FY86

FY91

FY96

FY01

FY06

FY11

FY16

-20% -40% Gold INR

Gold $/Oz

BSE Sensex

BSE-100

Term Deposit- 5Y

Source: RBI

20 Year rolling CAGR returns across asset classes 25.0% 20.0% 15.0% 10.0%

5.0% 0.0% FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 -5.0% Gold INR

Gold $/Oz

BSE Sensex

BSE-100

Term Deposit- 5Y

Source: RBI; 20 year rolling CAGR, for first data point returns CAGR is from FY80 to FY00

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10 Year CAGR returns across asset classes 35% 30% 25% 20% 15% 10% 5%

FY18

FY17

FY16

FY15

FY14

FY13

FY12

FY11

FY10

FY09

FY08

FY07

FY06

FY05

FY04

FY03

FY02

FY01

FY00

FY99

FY98

FY97

FY96

FY95

FY94

FY93

FY92

FY91

-5%

FY90

0%

-10% Gold INR

Gold $/Oz

BSE Sensex

BSE-100

Term Deposit- 5Y

Source: RBI; 10 year rolling CAGR, for first data point returns CAGR is from FY80 to FY90 Few things to infer from the above charts: 

These are pre-tax returns, basis the relevant market price/ indices level. Historically, equities have received a favourable tax treatment and thus equities outperformance on post-tax basis should be higher relative to other asset classes in the index return chart.



The charts are basis annual averages of asset class. On a YoY basis, the only asset class with stable returns has been fixed income, while equities have shown a very high volatility with sharp rises as well as sharp draw downs.



Fixed income: CAGR returns have remained far more stable relative to any other asset class. That is also expected from fixed income (as the name says), however, over longer periods, fixed income tends to under-perform relative to equity, as can be seen from the indexed returns & rolling CAGR charts.



Gold: in dollar terms has underperformed both debt and equities, however, INR returns have been better with ‘some’ periods of outperformance on a ten year basis. INR price is a function of gold price in dollar terms and our exchange rates and latter has also been a factor in favourable returns. Nonetheless, gold in Inr has had long periods of underperformance relative to deposit rates, with better returns only over last decade.

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Equities: returns have been volatile, as expected from equities; and for brief periods it has underperformed debt on even 10 year CAGR basis (early 2000s), implying, when looking at equities, in an unfavourable scenario, even 10 year might not be a sufficient time. However, when looking at 20 year CAGR basis, equities have consistently outperformed debt. Separately, tax treatment is favourable towards equities and on post-tax basis, outperformance should be higher.

Real estate: We lack composite data for Real estate dating decade’s back, to analyse long term historical returns. As per the new series of housing index, (Housing Composite Index for 50 cities), the index has grown from 106 in quarter ending June 2013 to 126 in quarter ending March 2018, a paltry CAGR of 3.5%. Also, real estate is a micro market play, which is clear from the graph below, as per which prices in some cities did not see any growth between 2007 and 2015. Even within cities, the disparity is huge (chart of Chennai, the biggest gainer as a city further below); implying real estate as an investment is suited to those who have deep understanding of micro-market. Investing just on the naive notion that prices will continue their move upwards, is ill-suited from financial planning perspective; especially when looked at illiquidity aspect and high transaction costs of the asset class.

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Basics of financial literacy

Source: NHB website (https://nhb.org.in/data-graphs/)

Source: NHB website (https://nhb.org.in/data-graphs/)

Risk management Oxford defines Risk as ‘a situation involving exposure to danger’. Although, I have worked in risk department at couple of places and my hairs have started turning white, I am yet to attain enough wisdom to talk about this subject in a sensible manner. So I will hide my incompetence behind words of great beings who walked on this earth, and add a line of my naïve interpretation with respect to the subject we are discussing (financial planning); although, the whispers might have been in totally different context.

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Basics of financial literacy “Risk comes from not knowing what you are doing” -Warren Buffet If you do not have a proper financial plan and are not working towards it, you are risking your financial security and imperilling your future financial well being. “It's better to solve the right problem approximately than to solve the wrong problem exactly” -John Tukey, an American mathematician Understand the problem first. It is not to generate super high returns from 10% of the portfolio that is held in trading account, but to effectively manage the entire networth across all asset classes to achieve financial security. The effort should be on getting the totality broadly right rather than returns from one asset class optimally. “The key to risk management is never putting yourself in a position where you cannot live to fight another day” -Richard S. Fuld, Jr. It is ironic that such a quote comes from the person, who presided as Chairman and CEO of Lehman Brothers during its bankruptcy. Nonetheless, the quote is fairly apt from financial planning aspect; not to concentrate too much money in such a way that a failure of a particular trading strategy/ security wipes you out completely, leaving no capital to fight back and grow back on. “Risk management is a more realistic term than safety. It implies that hazards are ever-present, that they must be identified, analyzed, evaluated and controlled or rationally accepted” -Jerome F Ledered, American aviation safety pioneer You can never make your portfolio 100% safe from risks; however, you must strive to identify and analyse possible sources of risks and the adverse impact it can cause; and chose to control it or rationally accept it. For a young professional risk from inflation needs to be controlled by targeting higher returns, while accepting risk of volatility emanating from higher exposure towards equities. “Outperforming the market with low volatility on a consistent basis is an impossibility. I outperformed the market for 30-odd years, but not with low volatility” -George Soros I think, I will just suggest to go back to the discussion on asset classes! Higher returns, inevitably comes with increased volatility. Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decision makers then need to reach a judgment about the probabilities, costs, and benefits of the various possible outcomes under alternative choices for policy. -Alan Greenspan I will just replace ‘economy’ with ‘life’, ‘Central Bank’ & ‘decision makers’ with ‘person’ and ‘policy’ with ‘his actions’, to read: “Given our inevitably incomplete knowledge about key structural aspects of an ever-changing life and the sometimes asymmetric costs or benefits of particular outcomes, a person needs to consider not only the most likely future path for the life but also the distribution of possible outcomes about that path. The person then needs to reach a judgment about the probabilities, costs, and benefits of the various possible outcomes under alternative choices for his action.

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Random brain droppings

Random brain droppings I have no section with a brilliant heading to cover these sub-topics, but I think understanding of some of these points is necessary to have a careful financial plan in place.

Buyer beware When you go buy a saree, have you noticed how the shopkeeper tells you that everything that you try looks good? His objective is to sell you a saree to pocket commission and will sell you dhoti as a saree, if you are willing to pay for it. However, while purchasing saree, unlikely that you will make a blunder as you know your need (silk saree or cotton saree or a cheap gifting saree) and your budget. Also, trying out few shops, gives you a fair perspective of what to expect and in what price range. In finance industry, the situation is inverted. Unless you are adept with financial basics and know what you are looking for; likely case would be that the person who is selling you financial product, would also be the one advising you on how it suits your financial plan. Can you think of possible problem here?? He is advising you on what is best for you, which would be selling you suitable product having lowest commission (that commission is your cost), but his own personal interest is served by selling you a product that has highest commission, irrespective of its suitability to you. How often, one is sold what is needed versus what has fattest commission is your guess!! Whenever you are being advised by a financial advisor, ask a few questions to them: 

What is the objective of this product? Is it insurance (risk cover), or return generation (equities) or fixed income (debt). Run away, if your financial advisor says all three. Keep things as simple as possible, using unidimensional products that serve just one agenda.



Always, always ask about the process of breaking up a policy/ product before the term and understand the fees and fines associated with it. Know what it costs to get out, if need be.



Get the details communicated to you on a product, over email from your advisor. I am not asking for a brochure here, but a brief explanation of plan over email or else record the conversation where he is explaining you the product, with his agreement. It is tragic, how often advisors explain plan features, but would back out when it is time to give that in writing.



Ask for advisor’s commission across the products he is advising you to buy.



If he refers you to anyone else, ask him for any referral fees that he will earn.

When asking about fees he earns, do not feel shy or think it is rude. Clear disclosure of fees and commissions to clients is considered as part of best practices in global financial industry.

Compounding While many understand this concept mathematically, it is one of the most underappreciated and underrated phenomenon in real world, especially with regards to personal finance. We all have would heard that famous story, of a courtier asking rice grains as reward from king, starting with one grain for the first square of the chessboard, two for the next square, four for the next and with each square having double the number of grains as the square before. The emperor happily agreed, but later found out that the rice grains calculated would not be available even in decades. That’s how compounding works!! The table below expands on the thought of compounding for long periods. The table represents Rs 100 invested initially, across different time periods and interest rate. If you start with Rs 100 and are able to compound it at 30% per annum for 60 years (not that long, you start in 20s and until your 80s!!), you will end up with 69 crores, starting just with 100; that is the power of compounding. Note that while difference between 8% and 30% wasn’t that great in first few columns, in the last column (60 years) the ratio between 30% compounding and 8% compounding is 67,692.

Narender Krishnani, CFA

Email: [email protected]

12

Random brain droppings

100 initially

5 years

10 Years

20 Years

30 Years

40 Years

50 Years

60 Years

8% p.a.

147

216

466

1,006

2,172

4,690

10,126

10% p.a.

161

259

673

1,745

4,526

11,739

30,448

12% p.a.

176

311

965

2,996

9,305

28,900

89,760

16% p.a.

210

441

1,946

8,585

37,872

167,070

737,020

20% p.a.

249

619

3,834

23,738

146,977

910,044

5,634,751

25% p.a.

305

931

8,674

80,779

752,316

7,006,492

65,253,045

30% p.a.

371

1,379

19,005

262,000

3,611,886

49,792,922

686,437,717

First quote for the section comes not from the greatest investor, but the greatest physicist, Albert Einstein. “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.” Below are some more quotations, by famous investors on their thoughts of compounding. I think it’s better to hear from them, rather than me on this subject. "Consider the Indians of Manhattan, who in 1626 sold all their real estate to a group of immigrants for $24 in trinkets and beads. For 362 years the Indians have been the subjects of cruel jokes because of it - but it turns out they may have made a better deal than the buyers who got the island. At 8 percent interest on $24 (note: let's suspend our disbelief and assume they converted the trinkets to cash) compounded over all those years, the Indians would have built up a net worth just short of $30 trillion, while the latest tax records from the Borough of Manhattan show the real estate to be worth only $28.1 billion. Give Manhattan the benefit of the doubt: that $28.1 billion is the assessed value, and for all anybody knows it may be worth twice that on the open market. Either way, the Indians could be ahead by $29 trillion and change. What a difference a couple of percentage point can make, compounded over three centuries” -Peter Lynch "Compounding matters and does so far more than people expect. The human brain thinks in a linear way which means that if we were asked to estimate what 10.22% compounded over 100 years would be then our answer is likely to be closer to 1,022% than 1,679,600%, something economists call exponential growth bias. This means that compounding is often underestimated and should be at the heart of long-term investing" -Marathon Asset Management "Compounding is one of my favourite words. Compounding is powerful. Warren Buffett did not become one of the wealthiest men in the world by suddenly striking gold in a single highly successful investment, but rather by compounding the value of Berkshire Hathaway at a 20 percent or so rate for 45 years. If an investor can achieve an average annual return of 20 percent, then, after 45 years, an initial investment of $1 million will appreciate to $3.6 billion. Wow! " -Ed Wachenheim "Investing is simply maximizing the rate of compounding for as long as capital can be employed net of fees and taxes. What strikes us as strange is how little we hear about compounding with regard to investing. We find the short-term perspective affecting the collective market psyche is focused on direction and immediate results that often limit the ability to truly accomplish outstanding rates of compounding" -Christopher Begg "Striving for sustained, uninterrupted compounding over long periods of time is smart investing, and that’s precisely our goal. Many people think of us as a “value investor” and others ask whether we are a value or a growth investor. We’ve started to say, we’re neither, we are a compounding investor." -Chuck Akre

Narender Krishnani, CFA

Email: [email protected]

13

Random brain droppings

Penny pinchers Every one would have known a man, who thought of working till 40 and retiring thereafter. How many of you know of people, who actually did that. The answer is probably no one and the reason is not that people start loving their jobs when they turn 40, rather the realisation that their financial corpus is not sufficient enough for their retirement needs. The only way to build up financial corpus is by saving and investing. For the latter to happen and you to enjoy the benefit of compounding, you need to save aggressively. Every Rupee saved is a Rupee earned. Every time you spend money, think about it and think if it is absolutely necessary to spend that money and if it is worth the value. Every Rupee earned from investing is as good as the money you earn toiling in office, so work on making your money work. If your financial networth is five times your earning, 20% return on that would be equivalent to you annual salary. So, pay good attention to your finances, and not just to the office work. I would like to leave this section, with few links below: https://www.businessinsider.com/self-made-millionaires-habits-build-wealth-2017-9?IR=T https://www.marketwatch.com/story/what-we-can-learn-from-frugal-millionaires-2018-06-25 http://www.bbc.com/capital/story/20181101-fire-the-movement-to-live-frugally-and-retiredecades-early https://youtu.be/RyF40JydVNU

Narender Krishnani, CFA

Email: [email protected]

14

Personal finance- hygiene factors

Personal finance- hygiene factors Heading of the subject is apt in context of financial cleanliness. Just like in personal life, simple hygiene practice goes a long way in improving your heath and quality of life; in financial parlance, some simple hygiene practices can ease out long term financial planning and help avoid unnecessary misadventures.

Keep it simple Simplicity is underrated in this complex world, especially in the world of finance. If you can’t afford a financial planner, who tracks all investments for you on a regular basis, the task then falls back on you and simpler your financial plan, is better off you are to track and implement your plan. There are two aspects of simplicity, account management and product management. With account management, I mean avoiding multiplicity of accounts. Some people I have come across have multiple savings account, half a dozen credit cards, few brokerage accounts, bank lockers in distant places, and few different insurance policies. I am always amazed, how do they keep track of their finances; are they genius or really dumb! Anyways, for the average IQ, the suggestion is to minimize and minimize. Cut down excess bank accounts, useless credit cards, unused brokerage account and insurance policies (not referring to term plans, but policies used for investments). The other aspect of simplicity is product management and the way to keep it simple is by buying simple financial products. Simpler the product, usually lower is the fees, easier it is to understand the underlying investments & returns driver and penalty on early redemption clauses etc. The need to go for a product which combines two asset classes or provides risk cover along with return generation, should always be looked at with initial scepticism and decision to invest should be made after thorough understanding of, what additional benefit a complex product offers over two simple ones. Personally, I prefer, simplest products with just one objective or underlying asset class, example term plan for insurance, equity mutual fund for investment in equities, PF for fixed income etc. A simple test for portfolio simplicity could be, a one hour test (that’s my own thought, not a thumb rule). If in an hour, you could check and write down on a piece of paper, all your money held across various financial products in different accounts and underlying asset allocation for those products; you pass the test. This will help you in long term, because financial planning requires regular oversight of portfolio and asset allocation; and simpler it is, easier it will be for you to monitor your path to financial wellness.

Information management This part follows in from above. Information management here refers to effectively manage, store and share information amongst family members. To keep track of your financials, I would suggest to have a simple listing in excel: 

Of all the bank accounts, with first holder, second holder and nominee



List of all investment accounts, second holder and nominee for each



Details of loans outstanding



All the credit cards outstanding with each family member



All the insurance policies and its nominees. When you think of insurance policies, also think of any allied insurance cover received as part of any account or any card!



Small brief of various land/ real estate holdings, where to find original papers and contact number of a broker/ dealer who helped in dealing with that property



Any bank lockers, its key and how to access it

Apart from information & tracker for self, this is also important from risk management perspective, in case of unfortunate death of the primary member who handles all the financial aspects of the family. As part of managing this risk, also good to have all of the accounts in ‘either or survivor’ mode, to avoid dependencies on one person.

Narender Krishnani, CFA

Email: [email protected]

15

Personal finance- hygiene factors Separately, with so many numerous accounts, policy papers, and other documents; how does one manage the information? I have a simple thought around it, which you may find helpful, a google drive account. Create a new account, where you park all important documents relating to family, financial plans, land documents etc. etc. The benefit is, account could be accessed remotely and with new age apps, you can scan a physical document instantly through your mobile phone to park it over in your Google drive account.

Sense of networth & tracker When you think of personal finance, do not think of isolated pools of revenue and expenses i.e. this money is for car purchase, this is for house purchase etc. etc. That concept is called bucketing and it might be helpful in certain situations, but the idea of wider goal and overarching theme of ‘networth’ should not be missed out. When you think in terms of networth, you think of all the money held across different accounts, financial products and real assets, less the financial debt (home, or personal loan etc.). And the target is to grow this networth over a period of time, not just a segregated pool of money invested in equities or that real estate exposure. While some can go around making a crazy model on this, as a basic simple start, you can think of using Excel from the previous sub-section, where-in you had listed down various accounts. As a next step, at every quarter end, write down the amount held across various accounts/ holdings. Gradually, over a period of time, you will have lot of data points to see how your networth is growing, which parts are lagging, which are doing well for you etc. etc.

Narender Krishnani, CFA

Email: [email protected]

16

Know thyself

Know thyself While this Greek aphorism was whispered in a totally different context; I will interpret that in personal finance as knowing your long term financial objectives and having a roadmap to achieve those objectives. This is more so important because financial media creates more noise than news, financial industry witnesses shockingly adverse events every few years, in between all this your neighbourhood uncle tries to sell you an ill suited plan which suits his pocket by way of fat commissions. Thus ever so important is to have a clarity of thought, clearly articulated objectives and a proper plan to achieve those goals. The financial roadmap differs from individual to individual depending on multitude of factors, of which we touch briefly on some below:

Financial objective This exercise will vary greatly in its output, dependent on the person’s age, his existing financial position and family liabilities. Broadly, if I have to think of financial objective, I can think of: Retirement corpus: The amount of money you require for retirement depends on a lot of variables, including expected retirement age, expected inflation, expected life span after retirement, expected return across asset classes etc. etc. It is impossible as an individual to get everything right to perfection in planning for retirement. Thumb rule is 25-30 times of annual expenses as retirement corpus, this number might be better off for those thinking of retiring at 60. If you are planning to retire early, let’s say by 40, you should shore up your numbers a bit so as not to run out of your capital during your last days. Also, this 25-30x thumb rule is in real money terms i.e. as at retirement, your corpus should be 25x of today’s annual expenses, increasing at the rate of inflation every year. To give you a sense of estimate and urgency of savings, google ‘retirement calculator India’, and the results follows long list of websites, some from very respectable financial institutions of this country. You can enter your current age, expected retirement age, savings etc., to arrive at monthly savings contribution needed for your retirement. The results from any two websites are unlikely to match exactly, as a lot goes in these calculations, but an average result from 4-5 websites should be a good starting point as an estimate of money you need to save monthly for retirement. It is just a one minute task, so in total we are talking about 5 minutes to get an average estimate across 5 websites. Children: I am clubbing the two aspects of children here together, education and marriage. While estimating monthly savings target, you first need to have an estimate of expense in present money terms. Similar to the above exercise, google ‘child financial planning calculator India’. This list that shows up, try estimating numbers at 4-5 websites, again in totality a five minute task. Also, please do not kill me for saying, in my personal opinion, both these expenditure are discretionary. While, you might want to provide the best college education money can buy, wiping out your savings and retirement nest for that might not be a good idea. In today’s setup, kid has ample financing scope in form of education loans, so as not to be dependent on the parent’s financial nest. Coming down to marriage, overtly expensive event that drain out your financial strength & wipes out your saving, is an act of stupidity and unadvisable. Home purchase: This section just pertains to estimating contribution for home purchase. There is a slightly more detailed section later on the topic. You will have an estimate of the house you are targeting, a one BHK / two BHK etc and estimated cost in today’s term. Go back to the kid’s calculator above and forget about kid’s education. Enter estimated cost of house in education expenses and in inflation, enter expected increase in house prices. The result will help you estimate the amount of money needed on a monthly basis to accumulate corpus for house purchase. If you are planning to buy on loan and want to estimate contribution for down payment, enter the expected down payment amount, instead of the value of entire house. Other goals: there could be other desires like leaving some money for children or donating some particular amount to a charity or anything else. Feel free to list that down and estimate the expected monthly contributions towards it.

Narender Krishnani, CFA

Email: [email protected]

17

Know thyself

While you do the monthly contribution exercise and estimate monthly contributions for each of the objectives, do note that most of these contributions estimated are static i.e. estimated at one level only across the investment horizon; however, your salary will grow with time, so shall your savings, and an opportunity to increase those savings amount with time to achiever better outcome than desired. Also, the exercise you did is not part of physics and with that I mean a task of precision. However good you are, you can’t predict inflation for 20 years, neither can you estimate returns for that long a period. The task of the exercise is to help you estimate broad savings level required towards your financial goals. As time passes by, your personal financial landscape will change & so shall your plan and monthly savings. You will have to keep revisiting your estimates time and again (preferably at least once a year), to make sure you are on the right path. For those who are just starting with their jobs and have no idea of their own marriage, leave aside kids marriage, the above might appear futile and academic. But certainly, what is not futile is aggressively saving and investing that amount. I cannot stress this enough, how beneficial saving and investing early on is, go back to the compounding section if you have any doubt.

Cash flow assessment & savings rate Previous discussion was on how much you need to save for your various financial goals. The next step is estimating whether you can realistically save that amount or not. For that: 

List down all the income sources that you have. This would include your and spouse salary, any rental income & any other business or side income.



In the above, do not include returns from financial investments. As you remember, you have already used that investment income in the previous section (in expected return form), when you were arriving at the monthly contributions. This would be double counting.



List down your monthly expenses and monthly average for regular one-offs like purchase of phones etc.



Once you have your salary and expenses, estimate the monthly savings that you can keep up with, going forward.

Check the above number against: 

Historical savings: If you are estimating a huge increase in your savings compared to your recent past, understand the reason behind it. Is it because you will switch from Scotch to Old Monk, or you will tell your wife to go to neighbourhood salon instead of Lakme!! You need to have a fair estimate of the drivers behind increase in savings compared to your recent past.



Your desired savings from previous subsection: Check the estimated savings versus the desired saving number from previous subsection. The two should marry each other, if your estimated savings is less than the desired savings number, modify your financial goals and repeat the steps, until the numbers are broadly inline.

Risk appetite This is the last puzzle piece in the know-thyself section. What number for expected return did you use in retirement planning calculators? One closer to historical FD rates or the one closer to historical equity returns? The number should be guided by your portfolio asset allocation; which would depend upon your risk appetite. In broad sense, risk appetite refers to your capacity to invest across risky assets and is a function of both, your financial situation & goals; and mental ability to sustain volatility. Formally, the two are called, ability to take risk and willingness to take risks. Let’s see one by one, what it refers to: Ability to take risks: Ability here refers to ability of your financial plan and goal to withstand volatility or ups and downs. Now if you think about it, what will give you that increased ability?

Narender Krishnani, CFA

Email: [email protected]

18

Know thyself 

Amount of surplus: If you have 100 but you require only 80, you can invest that 100 aggressively, so that even in case of some losses, your financial goals are not jeopardized. Conversely, if you require 100 but you have just 80; you can’t invest that 80 in riskier products, that it becomes 60, further straining your financial position & distance from goal.



Longer time horizon: refers to, how many years you have for your goals. If it is decades away, you have higher capacity to take risks. At 30, you can afford ups and downs of equities, if you are building your retirement corpus for age 60. However, at 58 and two years to retirement, your ability to withstand a huge drawdown from fall in equities is much less than at 30.



Plan flexibility: While you may target certain level of lifestyle and expenditure from your retirement fund, if your expenditure is a bit flexible and could be cut down in adverse scenarios that increases your ability to take risks. If you were planning for extensive and expensive holidays as part of retirement expense, something you are happy to cut down in case of adverse financial scenario that increases ability to take risks.



Stability of job and earnings: Simply, a stable and secure job increases your ability to take risks, while an unstable job (possible firings) or uneven salary, reduces your ability.

Willingness to take risks: This is the psychological aspect of risk taking and refers to how comfortable you are mentally with losses. There is no mathematical way to measure it and it keeps on changing as you grow and are shaped by various experiences. Also, this factor is shaped by your understanding of how different asset classes function over time and your personal experience with various financial products/ investments. The reason willingness is separate from ability is because although you might have higher ability to take risks and sustain a short or medium term loss in your portfolio; but due to behavioural factors, losses might stress you out and you might sell your positions at worst possible time. Even worse could be that losses result in stress and impacts your health. Risk appetite: is determined both by ability and willingness to take risks. While it is tricky to identify risk appetite of a person; one should spend some thought on the above factors and identify his ability and willingness on a scale of 1 to 5 and average the two to arrive at risk appetite. Thereafter, google ‘Risk profile calculator India’ and ‘risk profile questionnaire India’. The initial search results will give you links to some online quiz and pdfs with scoring methods, from some of the known financial institutions. Score at least 4-5 of these. The output would likely be a qualitative description like ‘aggressive’ or ‘moderately aggressive’, and will help you understand your risk appetite!!

Stitching it all together The three steps that you conducted, should tie up together and hold up together. What I mean here is: 

Your desired monthly savings (sum of retirement, kids, home etc.) depends on expected return on on investment in calculation. Your estimate for this expected return should be in line with your portfolio structure, which should be in conjunction with your risk appetite. If your risk appetite is very low (maybe you are nearing retirement age), your expected return should be closer to returns from fixed income asset class, while if you have very high appetite for risk, your expected return should be closer to average returns generated from equity.



Your estimated savings for future, should be inline with desired savings for your goals. If not, you probably need to modify your future goals and lessen your expectation.

As time passes by, your financial objectives might change, your financial health and savings ability might change and so might be change in your personality, driving changes in risk appetite. Overall, appreciate that this will remain a fluid exercise, so keep revisiting your estimates at least annually.

Narender Krishnani, CFA

Email: [email protected]

19

Liquidity and cash flow management

Liquidity and cash flow management Liquidity Access to cash!! In normal scenario, this aspect of finance goes unnoticed until there is a liquidity crisis. Although, in personal finance, this is less of a risk, driven by penetration of formal finance i.e. plastic money, access to ATM and quick loans from financial institutions. Also, most of the financial assets one holds are liquid although might entail some penal fees, like, early exits from mutual fund or breaking a FD etc. etc. That said, a basic plan is must to deal with any emergency situation requiring cash and liquid money. 

Cash: Have some cash saved always at your house. This might be needed rarely, but comes very handy, in case of emergency situation. I will leave that up to you in terms of what is the amount that one should keep but a low double digit thousands kept in cash doesn’t hurt.



Emergency fund: By this I refer to highly liquid emergency fund, cash you can just go out and withdraw from atm. This is needed once in a while, usually in medical emergencies but is worth the cost (lower return). In my opinion, have at least a lakh or two as liquid money, which can be accessed and withdrawn from ATM, any time. You can park this in bank account as a flexible FD (check for products detail with your bank) or any other product that offers interest higher than savings account, but completely accessible. Also, make sure ATM withdrawal limits are appropriate for the amount you are keeping as emergency fund.



Wider liquid fund: Thumb rule is to have six months expense as a liquid emergency fund to cover job loss or other emergency scenarios. So the difference between the emergency fund above and six months expenses, can be parked as a debt instrument which can be withdrawn with minimal expenses. Many debt mutual funds allow withdrawal without an exit fees or a minimal exit fees of 0.25%.

Cash flow planning Monthly expenses

Salary and other income

Receive all your income in one account

Incur most of the expense through credit card

Credit card

Investment accounts-1, 2

Narender Krishnani, CFA

Timely credit bills

pay card

Only have flow from and to the the investment accounts from the second savings account. Do not swipe this card for a free movie ticket, net banking or anything else

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Savings account-1

Transfer at least 75% of the targeted monthly savings as soon as you receive your salary; and balance savings from the previous month

Savings account-2

20

Liquidity and cash flow management Credit card for monthly expense: This point is very well articulated by the con-man himself, Frank Abagnale, on whom the movie ‘Catch me if you can is based’, in an appearance on google talk. Follow the below link and although entire video is worth listening, if short on time, start from 43:10. https://youtu.be/vsMydMDi3rI Every time you swipe your debit card, despite the technology, you expose yourself to a possible financial fraud, by leaving digital foot prints. Credit cards help you avoid that exposure and provide free one month liquidity. While you use credit card, do not use it as a personal loan tool. Also, I have seen some people having half a dozen card, personally, I think two are good enough for any person. You do not need so many cards, it just adds on to the complexity and eat away brain space. To consolidate family expense, you can also think of add-on card for your spouse/ kids instead of separate cards for everyone. Savings account-1: This is your primary transaction account. 

Receive all your salary and income (except investment income) in this account. Pay all your credit card bills and other expenses from this account.



As soon as you receive your salary, transfer 75% of targeted monthly savings to the Savings account-2. Also, transfer the balance savings from last month, as you had just transferred 75% of expected savings from previous month.

Savings account-2: This is your road to wealth and financial security. Do not use this account for any expense, be it on debit card or net banking or transfer back to the SA-1 for buying that new phone (it can wait). Ideally this should just be a one way account where in every month it receives monthly savings from SA-1. Use this account as a conduit for your investment accounts i.e. demat, mutual funds, etc. Also, this can be the account where you maintain that emergency fund of a lakh or two. Investment accounts: These refer to demats/ trading/ NPS and other investment accounts one might be holding. Practice, practice and practice, until you get the flow right and are able to control your expenses, to achieve desired monthly savings.

Narender Krishnani, CFA

Email: [email protected]

21

Asset allocation & fund selection

Asset allocation & fund selection Asset allocation This section discusses, how you should divide your money and invest across asset classes. Before I get into further details and my opinions on this section, here, I would like to share an anecdote on asset allocation. When Harry Markowitz, one of the founders of modern portfolio theory and recipient of Nobel in Economics was asked about how he allocates money to his retirement fund, he replied “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier. But, I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it. So I split my contributions 50/50 between stocks and bonds.” The creator of Modern Portfolio Theory, went in for far simpler way when it came down to investing his own money. Keep it simple. Asset allocation is the most important driver of portfolio returns over long term. Fund selection is important, but the primary driver for portfolio returns in long term is the weightage of different asset classes in portfolio over time. While everyone would like to know the perfect asset allocation approach that generates highest returns at minimal risk, unfortunately there is no precise answer. Although, modern finance theory does present new tools to approach asset allocation, most are mathematical & fairly complicated for a retail investor. Rather a simple approach using heuristics might better serve the need for simple investor. Asset allocation strategies Can be thought of as static, where targeted proportion of asset classes remains fixed over a period of time or as dynamic, where desired proportion keeps on changing with time. Static allocation strategies: This set of strategy keeps targeted proportion of debt and equity constant through out the time period. One example of that is the 50:50 approach used by Markowitz. Alternate for aggressive investors can be 70% equity, 30% debt approach; while risk averse investors can increase the fixed income proportion to above 50% and decrease equity weight. The issue I note with static strategies from a long term portfolio management perspective is, it assumes constant risk appetite for a person through out the time period. However, this is unlikely to be the case with a normal person. At 30, a person will likely have higher risk appetite compared to the same person at 60, however, if one followed static allocation strategy, proportion of debt & equity would remain the same. Possible solution to the issue is by using dynamic asset allocation strategy. Dynamic asset allocation strategy: The two common heuristics used here are 100 – age and 120 – age approach. 100 – Age: This is the most often cited thumb rule for asset allocation; and implies equity weightage equal to 100 – age. So at 30, 70% goes towards equity, at 50, 50% goes towards equity and likewise. 120 – Age: This is a newer cousin of 100 – Age formula, gaining prominence as increasing life span has also led to increased longevity risk (i.e. the risk of outliving your assets) and thus need to target increased returns by allocating higher proportion to equity than the earlier thumb rule. The formula is applicable the same way as 100 – age, implying 90% allocation to equities at age of 30, 70% at 40 and so on. Benefit of the two dynamic strategies is that it makes room for higher allocation to equities during early periods, when the time period to retirement is large. This allows for higher returns from compounding. Volatility aspect is managed by gradually reducing the equity components as the person approaches retirement. Target date fund approach: The third approach to asset allocation is a hybrid of static and dynamic approaches. First stage comprises of a static stage, with high allocation to equities, usually around 80% of portfolio. The allocation proportion is kept constant until middle age like early forty. The first stage is followed by glide path or second stage, where allocation to equities is reduced gradually from

Narender Krishnani, CFA

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Asset allocation & fund selection around 80% to 20%-40% over a period of 15-20 years (targeting retirement age), with proportionate increase in fixed income allocation. Third stage is again a static portfolio stage with lower but static proportion of equity. Impact on portfolio planning: The approach you use for asset allocation needs to be in conjunction with your risk appetite and you can fine tune it by a few percentage points, as per your thoughts. These are thumb rules, to help you guide on broad allocation decisions. Exact asset proportion on a daily average basis will always vary from desired, because the returns from asset classes would be different; covered below in portfolio rebalancing. So, try to get the broad totality right, rather than what is the best split up to last decimal. Once you have decided on the strategy and asset allocation; the proportion might be significantly different to your existing proportion. Do not take plunge the next day and deploy large proportion of your assets into equities. Do so gradually, over a few months to couple of years, to minimize market timing risks. After 2007 equities crash, it took a lot of time for markets to come back to the previous peak level and you don’t want to be in a position wherein you put half your portfolio in equities a day before the peak. So spread out your time period of increasing equity allocation. We are talking about decades of investing here, so a couple of quarters to build your allocation is fine. Separately, when planning and opting for your asset allocation plan, be vary of your short and medium term goals. If you intend to buy a house or marry your daughter, expense which might be large proportion of your financial networth, plan and gradually reduce your equity exposure over few years to fund such expenses. Portfolio rebalancing Whether you chose static or dynamic or target dated approach, almost always the actual portfolio split across asset classes will differ from the desired proportions due to different returns across asset class. This will result in the need to rebalance the portfolio and realign it to target weights. There are two common approaches to the rebalancing: Calendar rebalancing: At set dates (quarterly would be too frequent for individuals, chose semi-annual or annual), you rebalance the portfolio to desired weights. The benefit of this approach is that you do not need to track portfolio weights in between but look at only on set dates. Percentage of Portfolio rebalancing: In this, every asset class is given a band around its target allocation and the portfolio is rebalanced, whenever asset classes breaches the upper or lower band. As an example, if you are following 50:50 approach and have a band of 10%, you rebalance the portfolio when equity reaches above 60% or falls below 40%. The issue with this approach from individual’s perspective is that it requires constant monitoring, as you do not know, when equity will cross the threshold. In practice, I would suggest to have a mix of two approaches. Monitor at specific intervals, and have a band around desired asset weights. If proportion of asset class is outside the band on that specific date, rebalance otherwise do not. Rebalancing just for the sake of it to get the proportion correct to last decimal, will result in increased transaction costs and effort. What constitutes portfolio When thinking about portfolio from asset allocation perspective, count all your financial savings including amounts invested in equities or debt or real estate or gold, held through any financial product, be it provident funds, or FD or debt mutual funds or direct equities or ELSS or equity funds or ULIPS. Everything is counted in as part of portfolio. Real estate: If the only property you own is a house you live in, do not count that as your investment portfolio. Reduced monthly rental expense and thus lower retirement expense & therefore lower retirement corpus, already incorporates the benefit accruing from this property. Further, this can be relied on in adverse scenarios during old age, by reverse mortgaging the property. If you own an investment property, sole objective of which is to generate return and you intend to cash out at favourable price; do count that as part your wider portfolio. However, this would be sitting outside of your financial wealth and difficult to build into the asset allocation framework, because of

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Asset allocation & fund selection being chunky and you can’t sell half a room of the property to rebalance the portfolio to desired weights. Gold: Count gold value in portfolio that is held in financial form with sole objective to gain from price movement. Keep jewellery outside of the portfolio calculations (unless very substantial proportion), as it is not held with primary purpose of benefiting from higher prices, has emotional value and is an asset of last resort.

Investing in equities There are a few ways, by which one can invest in equities. Products for investing in equities Below list covers the major products for investing in equities. Exchange Traded Funds (or ETFS): ETFS are low cost funds (lower fees), with an objective to copy returns of the relevant index. They do so by mimicking the portfolio similar to that of index constituents. Investing in index funds is called ‘passive investing’ as the goal here is to achieve market returns rather than beating the market/ index returns. Passive investing forms big proportion of assets under management in developed markets, as the markets are quiet efficient and thus generating returns over above the index is really difficult on a post expense basis. However, in India, one can still benefit from active investing and the below options are all that of actively managed versions. Direct investing: This approach requires a lot of skill, hard work and mental aptitude. Opt for this method, if you really understand equities. If your idea is to do direct investing basis tips from relatives or an advisory, you might be better of transferring your money to a professional to manage. PMS and AIF: PMS is Portfolio Management Services (minimum SEBI authorized ticket size of 25 lakhs) and AIF stands for Alternative Investment Funds (minimum SEBI authorized ticket size of 1 crore). These funds take the money and manage it basis stated policy. When selecting a PMS or an AIF, look at historical returns and its volatility relative to peers and benchmark (somebody investing in small caps should not compare returns to BSE Sensex rather to the small cap index). When you chose a fund, do a proper due diligence, check the fees, redemption clauses and lastly do not put all your eggs in one basket i.e. invest all the equity money through one PMS or AIF. Also, it is not necessary that the guy coming on financial media having their own PMS advisory is the best fund manager, some toil in silence to generate returns for their investors without seeking glory in financial media. Do not get sucked by fame. ULIPS: I think below article published by Valueresearchonline, nicely sums up why ULIPS should be avoided in general relative to other options. These products add a layer of complexity by mixing two financial aspects of risk cover and return generation; and clauses attached to the policy will require careful reading. https://www.valueresearchonline.com/story/h2_storyView.asp?tax=1&str=26861 Equity mutual funds: Unless you were in hibernation for few years, you would have seen the add mutualfundssahihai. The website is run by Industry body and gives ample gyan on the subject of investing through mutual funds. The link below is the new guideline from Sebi, on categorization of mutual funds by types and subtypes, nicely laying out the details of allowed underlying investments for a fund of each type. https://www.sebi.gov.in/legal/circulars/oct-2017/categorization-and-rationalization-of-mutual-fundschemes_36199.html Below are the main sub-types of equity mutual funds: 

Large/ mid/ Small cap funds- funds investing in companies on basis their market cap. A large cap fund will invest most of its assets in big companies with multi thousand crore market cap (top 100 companies), while a small cap fund will target companies with smaller market cap (beyond top 250).

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Sector Oriented- targets companies of a particular sector like Pharma or FMCG or Banking etc. These funds will primarily invest in companies of a particular sector.

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Asset allocation & fund selection 

Thematic funds- funds that invest basis a particular theme like MNCs, Energy etc.

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International fund- targets international equities, with geography depending on the stated region. Some could be investing in ASEAN, other could be US while some other could be investing in International equities of a certain sector. Do note, that international funds are taxed as debt funds.

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Value Oriented- Funds investing with value based themes. Value funds invest in stocks trading below intrinsic value i.e. equities that are undervalued by the market. Value vs Growth investing has been a subject of plenty of debates and you will find enough arguments on both sides and performance favouring one over another depending on the time period analysed.

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ELSS- Tax savers fund, requires three year lock-in and are tax deductible under 80C.

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Hybrids- Those that invest in both debt and equity. They have a few sub divisions, basis there weightage to debt and equity.

Splitting your equity pool Again, there is nothing cast in stone, however, would suggest to split your equity pool into four to five sub-pools, targeting either a different investment approach or sub-section of equity markets. This is not relevant for active investors who understand equity markets and invest entire money on their own. 

Direct investing or PMS: If you are not an expert and keen to learn direct investing, do it with a sub-pool of equities and not with all of your asset. Alternatively, you can also invest in a PMS as part of one of the sub-pools.

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Market cap based pool: Plan two sub-pools, targeting different market caps of the large cap, mid cap and small cap. As you go down the path from large cap to small cap, expected returns tend to be higher, but so is the volatility. Chose, basis your comfort.

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International funds: Use this sub-pool to gain exposure to international equities and diversify away from domestic markets. Ideally this pool should be targeting a developed market, as your domestic market is an emerging market and thus from the purpose of diversification, an international fund targeting developed equity markets makes more sense. Be careful on the tax part, international funds although investing in equities are taxed the same way as debt mutual fund.

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ELSS: Possibly amongst the best tax savings instruments providing exposure to equities. The size of this pool would depend on amount invested for tax savings vs overall savings pool.

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Value oriented funds: There exists a few schemes investing basis this scheme and one can look to add value oriented funds as one of the sub-pool.

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Sectoral and thematic funds: Personally I am not a big fan of sectoral and thematic funds from the perspective of long term investing (with that I mean decade or multi decade long investing), as the sectors and themes that play out will keep on changing. This would make sense for a person who reads and understands financial markets and is adept at changing the course and rotate sectoral allocations. If you are one such person who can broadly time the sector and themes, put one sub-pool here.

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Hybrid funds: These funds invest in both equities and debt. Although one should keep it simple and allocate to debt & equity separately, there is a good case for ‘aggressive hybrid funds’. These funds invest at least 65% of the funds in equity, with proportion going up to 80% and at least 20% in debt with maximum of up to 35%. The benefit of these funds is that these are treated as equity funds for the purpose of taxation. So although, fund might have 30% allocation to debt, the tax pay-out on the entire income is basis the equity slabs, which is favourable compared to debt. While investing here, be mindful of allocation split between the two asset classes and that should also be incorporated in your portfolio asset allocation.

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Asset allocation & fund selection

Investing in fixed income securities Debt instruments, just like sub pools of equities could be of wide variety and different taxation across debt instruments further complicates the task of selecting the most optimal choice on a post-tax return basis. Taxation across debt instruments Unlike equities, where taxation is fairly similar across different investment vehicles, debt is a slightly more complicated place. For a general understanding on how different taxation regime might impact returns over long term, revisit the earlier tax discussion. Also, the most favourable instrument on post tax basis will depend on the interest rate offered and the tax bracket you are in. Consult your tax advisor for finer details of taxation across various debt instruments. Tax exempt instruments: These broadly include provident funds and come under EEE category i.e. the initial principal contribution is tax free (upto 80C limits), annual return or interest accrued is tax free and so is the withdrawal. This is the most favourable taxation regime one could ask for and over longer periods of time, this tax advantage greatly favours wealth accumulation, especially if you are in 30% tax bracket. Instruments taxable on accrual basis: This primarily comprises FDs, where the annual accrued return is taxable in that year. From the perspective of long term compounding, this is the worst place to be in, as over longer periods of time, this taxation regime results in lowest cumulative capital. There also exist tax-deductible FDs, where initial principal contribution is tax exempt but the returns are not. These are unfavourable compared to provident funds where the income generated is also tax free, in addition to the initial principal contribution. Also, these tax-deductible FDs can’t be pledged for a loan or redeemed before maturity, so no added liquidity benefit. Deferred capital gains taxation regime: These primarily comprises debt mutual funds, where tax is due when the asset is sold & gains realized. Even before going into applicable tax rates, remember from tax impact discussion, this regime is beneficial over the accrual one, even if same tax rate is applicable under both the regimes. In terms of regulations, if the gain is realized within a three year period, the gains are taxed as ‘short term capital gains’ at your tax slab rates. However, the interesting bit is, if the fund is sold after three years, the tax is applicable at the rate of 20% with indexation benefit. Indexation means, for the purpose of tax calculation, you can inflate your initial purchase price by the proportionate increase in the inflation index (google- ‘Cost Inflation Index’), thus reducing your taxable gain and effectively paying even lower than 20% on the gains. Technically, in this case you are paying 20% tax on the ‘real return’ i.e returns generated above inflation. Further, the tax is payable at the sale of debt funds, till then you can benefit from compounding effect and longer the time period held, longer the advantage from deferred capital gains tax regime. This is best option for long term compounding, beyond the EEE limits regime. Credit risk and interest rate risk Before investing in fixed income instruments, one should understand the two basic risks that impact these instruments. Below is a very simplified version of these two but google will give you all the details needed to understand the subject in depth, if you so desire. Credit risk: in plain simple words is a risk of non repayment by a counterparty. The ‘expected’ costs related to credit defaults is built into the interest rates. As an example, you have a total pool of 100 Cr to be lent out. You can lend this money to Government of India at 7% per annum with certainty that the money would be repaid and you will have 107 Cr at the end of the year or you can lend 1 cr each to 100 small companies, of which three will not repay the loan, but you do not know which three. If you are lending to the small companies, you would charge higher interest rate of 10%, so that even when the three companies do not repay the loan, you still have 107 crore at the end of the year due to higher interest charged. This difference between 7% on Government loan and 10% to the other pool is ‘credit spread’, and is to compensate lenders for

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Asset allocation & fund selection credit defaults. The reason I said ‘expected’ credit cost is built into the interest rate is because actual credit losses, you will get to know only later on. In the above example, basis expectation of default by three companies you charged higher interest; however, once the loan is extended, could be that all of them repay back (gain for lender) or also the possibility that default rates are higher than the 3% expected initially (loss for the lender). Although banks have their own credit department for assessing creditworthiness of borrowers to approve loans; there are also institutions called rating agencies, which assess company’s finances and provides credit rating. These credit ratings are provided as per rating scale of the agency and are available on their website (google ‘credit rating scale’). The scales follow a similar pattern across agencies, with AAA considered as most credit worthy, followed by AA, A, BBB, BB and so on until D. Where D represents that obligor is in default. Agencies in India include Crisil, Icra, Care and others; while S&P, Moody’s and Fitch are the prominent global ones, providing ratings across countries and continents. As you go down the rating scale, borrower’s creditworthiness declines and thus the interest on loans increases, to compensate for the expected credit loss. From the instruments we discussed earlier, PPF is credit risk free (as they have a backing of GoI), while FDs carry very low credit risks as the banks are very highly rated. Mutual funds invest across debt types, basis individual scheme objective with some investing in Government securities, others investing in high rated companies, while some may target lower quality borrowers. The credit quality they seek to invest in, is usually stated in scheme objective; and is as per the Sebi categorization guidelines. Interest rate risk: is the risk of change in prices of fixed income securities from unexpected change in interest rates. Sounds cryptic? Let’s take an example. Yesterday, you bought three separate bonds with maturity of one year, five year and ten year; each at 100 Rs, having 100 Rs principal amount and paying 10% interest per annum. Today, after central bank meeting, interest rates increased and new loans are made at 11%. You went to sell your three loans of different maturities in debt capital markets, at the same price you bought the bonds at i.e. at 100 Rs, but why would anyone buy Bonds from you when they are getting higher interest of 11% on new bonds being issued today. You will have to lower your price, so that buyer is effectively getting the same return whether he buys from you or the new bonds paying 11% interest. How much do you need to lower the prices? 

For the one year bond, approximately by 1%. So, you sell the bond at 99 Rs. The buyer at the end of the year gets 110 Rs (100 principal and 10 interest) on investment of 99 Rs i.e. 11% vs the 11% he would have made if he invested in fresh bonds issued today at 100 Rs with 11% interest.

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For the five year bond by approximately 5%. You sell the bond at 95 Rs. If he bought a new bond, he would have received 11% interest every year and 100 Rs principal at the end of five years. When he buys the older bond from you, he will receive 10% interest every year and the lower one percent interest each year would be compensated by way of increase in bond price by one Rs every year from 95 at which he bought to 100 at the end of five year period.

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For the ten year bond, the answer would be approximately 10%, with similar concept i.e. price increasing by one Rs every year from 90 Rs today to 100 Rs at the end of ten years.

Similarly to above example, instead of increase in interest rates, if the rates were to decrease by 1% to 9% percent, that would have resulted in increase of bond prices, a gain for you. So one thing gets clear, longer the tenor of Bond, higher is the impact on its price for similar change in interest rates. Mathematically, this is measured by ‘Duration’, which represents weighted average maturity of all of the bonds cash flow. Weighted average means, the ten year bond also pays 10% interest every year, so its weighted average maturity would be slightly less than ten years, when the bond is to be repaid. There are different types of duration and ‘Modified Duration’ is used for price change calculations. Also, exact price change is also impacted although to a smaller extent by something called as ‘convexity’. But if you understood the basic idea of interest rate risk i.e. longer the term of the bond, higher interest rate risk it carries, you should be fine. Let fund manager worry about the formulas and decimal changes.

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Asset allocation & fund selection Splitting your fixed income pool When planning for asset allocation across fixed income, split your bucket into three to four sub-pools. Provident funds (both EPF and PPF): Both have slightly complex regulations around its maturity, withdrawal rules (limiting liquidity) etc. Also, total deductions under 80C is 1.5Lakh and separately, total contribution to PPF in a year is capped at 1.5 lakhs and this amount is in excess of EPF deposits made during a year. If you are looking at fixed income investments from longer term asset allocation perspective and ok with illiquidity of the asset, the first and foremost bucket you should fill is Provident Funds, for one simple reason that it forms part of the EEE taxation regime. FDs: Not the best instrument to allocate your money from long term perspective due to tax inefficiencies. Debt mutual funds: One can look at few options from debt funds menu to allocate sub-pools. Since we are discussing long term investing, I am not touching money market and short duration funds; which provide lower returns in long term. Also, when investing in debt funds, do look at the underlying portfolio of bonds held and maturity so as to get a sense of the fund vs its category. The information is available on many websites. 

Dynamic bonds: Dynamic bond funds invest in bonds across debt maturities and fund manager has the flexibility to change fund duration, as per his views on interest rates. This represents a good option to allocate money for someone who does not track interest rates and has no view on it. Let the fund manager take that pain.

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Corporate bond funds: These invest in bonds of Indian corporate, at the higher end of credit rating, so the credit risk is limited here and could act as another sub-pool for debt.

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GILT funds: These invest at least 80% of the portfolio in Government Securities (no credit risk), but can invest across maturities depending on the views of the fund manager.

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There are many other classifications for debt (refer to the Sebi link). One can read through, understand and invest according to his financial plan.

Selecting mutual funds This section is common to both debt and equity funds, as the factors to be looked at and resources are broadly common for both. Generic gyan 

Direct vs Regular fund: Mutual fund schemes are offered in two types, direct and regular fund. Regular funds pay brokerage to your advisor/ platform from which you purchased the fund; while a direct fund does not. So, naturally a ‘Regular fund’ will have higher expense and thus lower return by the commission amount paid out to advisors. Avenues for buying ‘Direct’ schemes are limited and as far as I remember, you can buy it from platforms like Mutual Fund Utilities, Zerodha, Paytm and also directly from mutual fund house websites. There can be other platforms as well offering investment in direct funds.

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Mutual funds are subject to market risks: What it means is that your return from a mutual fund would be dependent on markets and that is applicable for both debt and equity. Sharp correction in equity markets will lead to losses in your equity funds; but not that debt is insulated. If there is a default by a company (remember IL&FS), whose bonds are held in fund scheme, will result in losses. Similarly, for higher duration funds, increase in interest rates will result in losses due to price changes.

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Active funds: Mutual funds are active funds i.e. fund manager of a mutual fund tries to generate additional return over the benchmark, whether he succeeds or not is another story. Some funds will succeed while some might fail at beating their benchmark.

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Benchmark: What is a benchmark? It is an index that closely reflects the funds stated investment style. For a large cap fund the benchmark could be Nifty Fifty or BSE-100; while for a pharma fund

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Asset allocation & fund selection benchmark could be Nifty Pharma. Comparing with Benchmarks helps understand whether the fund manager performed better or not relative to the index of his targeted style. 

Diversification: For direct investment in equities, it is recommended to achieve adequate level of diversification by investing in 18-20 securities. But do you need 18-20 mutual funds as well to be adequately diversified?? The answer is no. Every fund is already diversified in itself, holding multiple securities. One should not overcomplicate and should look at adding only one or two funds for each of the asset sub-pools.

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SIP or lump sump investing: It is actually not a relevant question. Savings and retirement planning is a regular monthly process, so by design you should be investing monthly. Buy in lump sum every month or open a SIP, hardly matters. SIP may just ease out things operationally. Separately, if you are setting up your portfolio and asset allocations for the first time, increase your exposure to equities gradually to avoid market timing risks.

Fund specific factors When selecting a fund, one can look at many factors. Below is a short list and not an exhaustive one. Also, although the list looks long, this is not that big a task, if you know what you are looking for. I find interface of Valueresearchonline (https://www.valueresearchonline.com/) quiet easy, but I am sure there would be other websites, with this data for analysis. 

Performance: Check the fund performance within its category. Look for performance consistency over last five years; ideally, should be a top quartile performer across one, three and five years.

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Fund ratings: Check the fund ratings at Valueresearch and Morningstar. The fund selected should be amongst the top rated ones in their basket. These ratings incorporate both risk and return factors, so if the fund you intend to select is rated low, investigate the reasons.

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Exit load: Penalty charged for withdrawing money before a set time period. The time period as well as percentage penalty applicable varies for each fund. So, sense check that.

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Portfolio: Have a look at the funds portfolio to understand fund style and also at the securities for basic understanding of where the money is invested. Fund style for debt primarily means credit quality and duration. For equity, that refers to market cap and investment style (growth/ value).

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Fund manager: Look at who is managing the fund and for how long has he been managing it. Recent changes should be looked into.

National Pension Scheme A complicated scheme, nonetheless with its useful benefits. Below is a quick summary of the pros and cons of Tier-1 account and why investing at least the tax exempt 50,000 makes sense. I will skip the myriad rules off NPS, which you can google. Investment choice under NPS: https://npscra.nsdl.co.in/download/Investment-options-under-NPS.pdf Recent (Dec 2018) tax changes, make it completely exempt: https://www.livemint.com/Money/S2hdX9KdrYjKRAWgJYCX6I/NPS-rule-changes-explained-in-10points.html Benefits 

Tax exemption: Contribution of 50,000 is exempted over and above section 80C. That is a great head start for an investment product vs other options, especially when you are in higher tax bracket of 30%. Further, the return generated is entirely tax free during accumulation phase as well as retirement phase, a great benefit for long term compounding.

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Investment options: Although it is slightly complicated, but NPS offers good flexibility in managing the investment options. By opting for an Active plan, one can select desired asset allocation mix

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Asset allocation & fund selection to a large extent, as per his asset allocation targets. If not, one can chose one of the Lifecycle options, of which Aggressive Life Cycle Fund, resembles a target dated fund approach. Drawbacks 

40% Annuity: Annuities are not the best products when it comes to return and compulsory requirement of purchasing an annuity from 40% of the corpus is a slight drawback.

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Illiquid: You can’t sip in to this asset as and when you need and have to wait until retirement age (60). It gets worse, if you plan to retire early and liquidate the plan, you are required to purchase annuity of 80% of the value. Although I see it as an issue, it is not a major one, given the fact that you can plan for liquid pools elsewhere in your asset allocation.

Overall, the primary benefit of investing in NPS comes from the 50K additional tax deduction and as long as one gets that benefit and is in a financially good shape, to afford an illiquid asset for a long period of time, one should take benefit of the plan to the tax exempt limit.

Narender Krishnani, CFA

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Real estate- home sweet home

Real estate- home sweet home If one is investing in real estate, I wish him luck. I have limited understanding of micro markets and real estate in general to comment whether one should or should not invest in real estate. May be, you would like to visit NHB site to understand historical price movements in the relevant micro market that you are targeting. For people buying a place for living (not investment), that’s a long term decision and I am sure, everyone taking that step would be consulting from friends to family to internet articles to your financial advisors. I have just a few pointers for you to ponder over while you search for that perfect home sweet home. Different individuals will have different reasons for purchasing a house. Introspect and try to understand yours. I have tried to list down a few possible reasons, but certainly this is not an exhaustive list. 

Fear of missing out or feeling of lagging behind, while your friends or relatives are buying a house. Understand that no two person’s financial situation and targets are same. Your purchase should be based on your thoughtful plan rather than competition from peer set.

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I have decent savings, so let’s buy a house, I can sell it off anytime. Properties are illiquid and in bad markets it might take year or two to find buyer willing to pay the right price. An emergency liquidation can cost you dearly.

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Property prices are going to go up, so let’s buy a house now. While we don’t have extensive data, going back decades, last ten years return data as per NHB is nothing to write home about. So, maybe you should find a better reason to buy a house.

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You were offered a great deal. Make sure, you actually got one and do proper due diligence.

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Government is offering tax benefit. Government policy is transient, you might not want to load up on 20 year loan for a beneficial tax policy that may last just over a couple of years.

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Save on rent. In India, rental yields are very low (2-3%) compared to interest rates on loans. So while you might save on rent by buying a house, for an equivalent house, you will have to shell out much larger EMIs on loan.

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Home ownership might bring peace of mind. This is a behavioural factor and you have to judge its importance. For some, this could be a really big factor, especially if there is no property owned by parents.

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Your career is stable and family planning done, with enough cash/ salary to spare towards a house. Possibly the best and most sane reason on the list to purchase a house.

Some of you might have some other reasons as well! My intention here is to have you spend some thought on your reasons and if it’s a sensible one. Below, some more pointers: 

Medium to long term view: Purchasing a house is a medium to long term affair. Have at least a 57 year view while buying a house as you are not going to flip around from one house to another every few months. Real estate is illiquid.

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Family planning: Looks like an odd place to discuss home purchase. But, aren’t you planning to buy the house for your family. So give a thought on this. Buying a house just for buying a house, might later be a misfit. You might have thought of two kids as per your family planning, but the house that you are buying is 1BHK. Will that be sufficient for you as your family expands? Or your Father who is about to retire and wants to shift with you post his retirement. Is the house suitable for his need? Think of your needs, at least a few years down the line.

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Career stability: With that I mean, is your job transferable or are you willing to move across cities in search of better job in next couple of years? This aspect becomes more important, if you are planning a purchase on loan as you will have EMI for a house in different city, while you might be paying rent in different city. Imagine, an EMI for a house in Delhi, while you pay crazy rent in Mumbai, which would not be compensated by incoming rent from Delhi. Add on to it, the nuisance of managing renters while you are in a different city.

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Real estate- home sweet home 

Travel: This is possibly the most neglected point in search for own roof. I have seen friends who could live quite close to office on rent but travel 2 hours each way, because they bought a house at the edge of a city, only place where they could afford to buy a property. If you are intending to do such a thing, make sure you are up for long city travels, usually in public transport (as Uber and Ola could be quiet expensive for such long distances). I would suggest once you have zeroed in on such an area, try living there for a month on rent and travel to office everyday. If you are comfortable, go ahead and buy your dream home.

After a deep thought you have finally decided to go ahead and buy a house. Now you are looking for properties, but how expensive a house can you afford? I do not think there is a fixed and clear cut answer to that, and it would depend on your age (or rather working age left), salary (family’s take home cash salary), monthly spare cash after expenses, desired level of saving for important goals and your existing networth. I think one can look at two ways to approach this question: 

If you remember the ‘Know thyself’ section, you would have already done this exercise to estimate and contribute towards home purchase. After purchase, monthly savings towards down payment would be replaced by home loan EMI. Make sure, your retirement corpus is not wiped out and EMI burden is not so much that you can’t contribute to your retirement corpus.

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The other approach could be to invert and analyse, what you can’t afford. Any house for which you are wiping out your entire savings for just 20-30% down payment and for balance you are taking 20 year home loan with EMI that makes up 50% of your salary, is something that’s out of your reach. Industry thumb rule is that EMI should not be more than 30%-40% of take home salary, but even this could be unaffordable if it leaves you with no cash to save for retirement.

In my personal opinion, sweetest spot to buy a property is late thirties or early forties. This is a stage, when a person is broadly settled in terms of professional and personal journey, with hopefully adequate savings to afford a down payment and still having a long work life ahead to afford a long tenured EMI based loan.

Narender Krishnani, CFA

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Personal risk management

Personal risk management Life insurance Personally, I see this as one of the most important elements of personal finance. Insurance helps financially dependents to maintain their lifestyle in case of death of the earning member. One can’t possibly minimize the emotional pain of a loved one passing away, but there is absolutely no reason to not take care of and mitigate the possible financial pain that can come from death of an earning member. There are multiple types of insurance policies, a simple google of ‘types of life insurance’ will walk you through different ones. These different types of policies might serve some specific purpose in certain scenarios, but for a general person, most apt policy for risk cover is ‘Term plan’. Term plan is really simple, you pay annual premium for the policy period (term life as long as 40 years) and if you die during that period, your family gets the sum assured. If you don’t, you do not get back anything. The reason this policy makes sense from financial planning perspective, is that it is the pure risk cover (death) policy, a unidimensional product as I like to call it. It helps keep your financial plan simple and segregated. Also, being the pure risk cover policy, ratio of risk cover to annual premium is quite high, at around ten thousand annually, a thirty year old can get sum assured of one crore. Why is this important, lets say because of any reason (health expenses or a baby in family or buying a house etc.), your annual savings come down to very low levels from average, even in those scenarios, drain on financial resources for risk cover would be low compared to any other policy type. Do not mix insurance and investment together, it is not an efficient product, keep it simple! Insured amount: There are many ways of calculating the insurance amount, from human life value, which basically discounts your estimated remaining income to a normal thumb rule of 10-12 times your annual earning. Just like our previous discussions, this is no science, so there are no fixed guidelines or benchmarks. The idea here is to be broadly correct rather than being horribly wrong. So let’s start with 12x annual income and look at some factors, basis which you might want to modify the multiple: 

Dependents & age: o

You are still single and your parents are financially independent or dependent to a very small extent, reduce the multiple.

o

Conversely, you are in your early thirties with wife and kids, also your parents are financially dependent. What you are looking at is long period of time, where your parents and your wife would need financial support from the insurance money. Significantly increase the multiple.

o

You are in your mid fifties, your kids are almost settled, you have also saved ample financial nest for your self and your wife, reduce the multiple

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Family backing: You come from a well to do family and certain that in case of adverse event like your death, your wife and kids would be taken care of, reduce the multiple. Conversely, no other source to fall back on, in that case, better to err on side of conservatism and increase the multiple.

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Financial burden: You have taken a home loan or have other loans. Increase the multiple to cover the loan amount.

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Health cover: If you do not have proper health cover for your family like that provided to Government employees, you might want to increase the multiple slightly to cover one-off expenses for your parents/ spouse.

Again re-iterating, if you ask two person for the exact amount of risk cover, the answer is going to be different. So do not lose night’s sleep trying to figure out the exact best amount for your family, but try to get it approximately correct. Be slightly conservative and err on the side of caution by taking adequate cover, but be mindful to not be too overprotective and buy large excessive cover.

Narender Krishnani, CFA

Email: [email protected]

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Personal risk management Insurance cover is a nominal amount: what it means is that the amount remains fixed over the term of the policy and does not increase with time. If you remember the inflation discussion, 100 Rs today is not going to be equal to 100 Rs in future. How do you tackle this problem and ensure adequate risk cover. Buy insurance policy with some bit foresight i.e. think of your salary and liabilities three to five years down the line in future, when assessing insurance adequacy today. Also, repeat the insurance adequacy assessment process every few years or in case of major change in your financial liability; and adjust your cover accordingly. Insurance plan riders: Understand one thing in finance, there is no free lunch. The benefit that you are purchasing is adequately priced-in in terms of probabilities by actuaries. So do not just add all the riders thinking it is cheap, but look at what might be suited to you and your life style. For a brief discussion, I would highlight two riders: 

Critical illness rider: This rider provides for additional benefit payable as lump-sump or periodically in case of diagnosis of critical illness. These usually include cancer, heart attack, cardiac surgery and kidney failure. Always read the fine print of what is included and excluded in the above.

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Guaranteed insurability rider: As discussed above, insurance needs might change with time and thus you might need to increase the cover. This rider provides option to increase the insurance cover without further medical examination, regardless of the state of your health. Basically this rider allows you to increase your policy amount in future and guarantees your insurability. Again read the fine print for T&Cs.

Beneficiary selection: If you have both parents and wife as dependent; and have had disharmony in past, split the amount in insurance policies. Do not just assume that once you are dead, your parents will happily take care of your wife or vice versa. I am not replaying script of Baghbaan here, but be aware of such possibilities and ensure well being of both your dependents, by splitting the insured amount legally. Investment advisor selection: In most cases, investment decision maker in a family is also the primary earning member and one with largest insurance cover. After death of that person, family will receive a large amount of pay-out, in multiples of annual income. Now this pay-out needs to be properly managed, as this corpus is to support the family for years and in some cases decades. Think of a financially adept person, whom you can rely on in your absence to guide your family members through financial decision making. Discuss about the name of that person with your family members and once zeroed in, apprise that person of the responsibility that you expect him to take-on, in case of your unfortunate absence. Declaration to insurance companies: Be as detailed as you can be here. Be thorough, when declaring family and self medical history. Always always declare if you smoke or drink. Do not fear, what your parents will think of, if they read the policy document! You are buying risk cover for your family and the last thing you want is the cover to be rejected for misdeclaration. Also, if you seek any clarifications from the insurance company, seek it directly from their call centre and record that conversation for reference in future. If seeking explanations from advisor, make sure that person is a representative of that insurance company and get the explanation in writing, over paper or email. Selecting an insurance company: There are articles aplenty on online forums and websites guiding you on how to select insurance company. My few cents here are: 

Do not fear purchasing insurance from a private insurer! These private companies operate in a well regulated industry, so they can’t pack their bags and runaway next day, if that is your fear.

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Buy insurance from one of the leading insurers, by leading I mean top 4 or 5 of the country. Although, going with majority does not necessarily mean that you are opting for the best or the cheapest option, it just gives some mental peace knowing the scale of operations.

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Always look at the historical claims settlement ratio of the company. Good ones will have it around or above 97%. Just google ‘Irda claim settlement ratio term insurance’ and you will get ample links with latest claim settlement ratio, average pay-outs etc.

Narender Krishnani, CFA

Email: [email protected]

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Personal risk management

Health insurance While the section below is short guiding you to links, managing health risks is very important. It can wreak havoc on financial savings. https://timesofindia.indiatimes.com/india/health-spending-pushed-55-million-indians-into-povertyin-a-year-study/articleshow/64564548.cms Selecting an apt health insurance, as per your family needs is a bit more complicated than selecting a term plan. There are plenty of articles that you can search, I will share just one link here! https://www.quora.com/What-should-I-look-for-when-buying-health-insurance-in-India The answers in above link, include some relevant industry people, so worth a read. I have just one pointer here: Insurance sum is a nominal amount: It is the nominal value i.e. the cover remains fixed over life time. So, if you think 5 lakhs is sufficient for your life; this 5 lakh at 10% medical inflation, in 10 years time will be 13 lakhs and in 20 years time, will be 34 lakhs. 20 years is not a distant horizon, it is just half of your working age of 20-60. To add here, some policies have sub-limit on room expense. While the overall amount you chose might be sufficient, think from the perspective of inflation on room rent as well.

Narender Krishnani, CFA

Email: [email protected]

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Check-list

Check-list Do not be overwhelmed by the list of tasks. Although, saying, it is one time exercise would be incorrect, as financial planning requires continuous monitoring and action. However, setting up the financial framework initially is certainly more tedious. Once you have the broad framework ready & under implementation, following it up on a regular basis will not demand more than a few hours in a month. Further, financial plans is about decades, so you do not have to rush through all the tasks tonight or this week or this month. Have a realistic timeline of setting your house in order! That should not be a month or a quarter, rather a few quarters. Split the wider target into smaller doable tasks and approach them one by one. Slow, as it might be but take ‘conscious’ steps towards your finances. Assuming, only a few hours every weekend, below, can serve as a basic timeline for getting your plan into action. Feel free to modify as per your need & speed. Month 1: 

Current listing: List down all of your/ families accounts, policies, investments etc. All the holes, where your money is parked. Understand underlying asset class for investment products, current risk cover you have, any onerous policies or investments that are not efficient from fees or return perspective. By the end of the month, target to have an understanding of your current networth, how it is split across accounts, products & asset class.

Month 2 & 3: 

Risk cover: Get adequate life and health cover. The task is not simple, you will have to read about policies and clauses, introspect on your need, get into action and sign-up for a policy.

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Account planning: Plan on how you want to consolidate your accounts and structure your cash flow. You might want to read on features of credit card, savings account, fees on brokerage accounts etc. Have a clear structure in your head, of how the money will flow around accounts and damns (investment accounts) where it will be collected.

Month 4 & 5: 

Account opening: If you want to structure your plan around existing accounts, less work for you. Else take these two months to open up various accounts, link them together and get them up and running.

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Understand your plan & targets: Go through the steps of know thyself section i.e. plan your goals, estimate desired savings for those goals and targeted asset allocation, basis your risk-appetite.

Month 6 & 7: 

Cash flow management: With all accounts set up, desired goals and monthly savings estimated, try saving as per your estimates and start working on your cash flow model i.e. money flow across expense and investment accounts.

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Fund selection: Now that you have desired asset allocation targets, plan and select the funds for each of the asset class.

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Tracker: Build a simple tracker in excel, listing down your account and relevant details like owners, nominees and any other important details.

Months 8 & 9: 

Consolidating it all: Gradually move your existing investments into the new funds and inline with your desired allocation. If current equity exposure is low, build it up slowly over a couple of quarters/ years and until then, park it in fixed income assets.

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Old onerous products: Some policies and products might have high penalty on liquidation. Do a cost benefits analysis; and if the costs are high, let the products run-off naturally.

Narender Krishnani, CFA

Email: [email protected]

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Check-list 

Closures: Start closing the accounts that you do not need, I mean credit cards, brokerage accounts, savings account etc. Close whatever is not part of your framework; no point keeping it just because it is free.

Hopefully, by the end of one year, you will have a simple enough financial structure to pass one hour hour test and are able to list down, all your money across accounts & products with underlying asset classes. Going forward: 

Maintain the networth tracker, listing down your money and asset allocation, at least every quarter. Look into any major variations. Check, and asses, if monthly savings are not inline with target.

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Rebalance asset allocation every six-months or a year, a period you chose.

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Annually revisit your financial goals, planned monthly savings and targeted asset allocation; and modify them basis developments during the year.

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Revisit risk covers (life and health) every three to five years.

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If there has been any major event, like addition or passing away of family member, substantial inheritance etc.; reassess and restructure your plans.

Wish you a rewarding investment journey!!

Narender Krishnani, CFA

Email: [email protected]

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About myself

About myself A victim of inflation, laziness and carelessness. Yes, I dedicated this work to myself!! and my unfortunate brethren. Email: [email protected] Website: http://financialplanningsimplehai.com (under construction! Update to this work (if any) shall be shared on the website) Professional & academic history could be accessed from below link: www.linkedin.com/in/narenderkrishnani

Narender Krishnani, CFA

Email: [email protected]

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