Monday, 4 August 2014

Importance of goal based investing

There are many disadvantages of investing money directly without considering one’s goals, liquidity requirements & financial profile.

Why investing in fixed income is better for short term goals & equity better for long term goals?

Fixed income means investments in fixed deposits, bonds, debentures, government securities, etc.
All funds required for next 3-5 years should be put only in fixed income securities like debt mutual funds. Click here to know why debt mutual funds are a better investment than cash and fixed deposits.
Investments for long term (more than 5 years should ideally have a high proportion of equity. In the long term, equity has historically outperformed fixed income & has given very high returns.
Take these 2 examples
  1. Short term

    `10,000 invested at 8% (debt) will grow to `12,600 in 3 years and if invested at 15% (equity) will grow to `15,200 in 3 years.
    Thus we see that growth is not very high in short term even for equity.
  2. Long Term

    `10,000 invested at 8% (debt) will grow to `46,600 in 20 years, if invested at 15% (equity) will grow to `1.64 lakhs in 20 years.
    Thus we see that in the long term, equity can provide very high returns compared to fixed income.

What are the disadvantages of not investing as per one's goals?

Consider these two examples
  1. An investor invests all his savings in equity without considering his short term liquid needs. Due to volatility of stock prices, it may happen that the value of his portfolio decreases in the short term. He will now have to utilize a higher portion of his savings for his liquid needs. Had he kept some amount aside for short term liquidity needs, he would be better off.
  2. Similarly, suppose an investor invests all of his monthly savings of `30,000 only in fixed deposits, inspite of his strong financial profile and high tolerance for risks. After 10 years, considering post tax returns of 8%, his portfolio would have increased to `54 lakhs. Had he invested in equity he would have a corpus of `85 lakhs, considering 15% returns. If one stays invested in equity markets for a long time, the probability of lower returns decreases considerably.

So how should one invest after considering one's goals?

Before starting to invest, one should identify the cash outflows required at various points of time according to one's goals. This helps the user to identify the funds requirement for short term, medium term & long term.
  • For short term (0 to 3 years), one should always invest only in fixed income investments like FD, RD, Debt Mutual Funds. This is because there is not much difference in absolute returns of fixed income & equities in the short term. Also, equity is very volatile in the short term & can lead to short term losses.
  • For mid term (3 to 10 years), one should invest in a mix of fixed income & equity depending on one's risk profile & duration of investment. This is because equity returns have generally been positive & very decent in the mid term. But one should not take risks at the cost of financial security & hence investing according to risk profile is important.
  • For long term (more than 10 years), one should invest according to one's risk profile. Equity has historically given very high returns in the long term & has rarely given long term returns less than that of fixed income. Investor should keep this in mind

No comments:

Post a Comment