How to secure your financial future
Rule 1: Know your worth before you begin
To reach the finishing line, you must first know where the race begins.
As any financial planner will tell you, figuring out your net worth is the first step towards formulating a successful financial plan.
The best way to do this is by drawing up a list of your assets and liabilities.
It will also give you a broad idea of your current asset allocation. Taking stock of your current status is necessary to help you make informed financial decisions. The slowdown may have affected your annual increment.
Volatility in the stock market may have prompted you to stay out. Before you plan to invest, sit down and take a fresh look at your financial situation.
Your ability to take risks determines the investments you should opt for
Once you have figured out where you stand, find out your attitude towards investing.
Your ability to take risks determines the investments you should opt for. If your stomach churns whenever the Sensex goes into a freefall, equity is not for you.
Stick to the safety of debt options or take exposure to stocks through mutual funds. On the other hand, if a 20-25 per cent fall in value doesn’t upset you, equity can be a great way to build wealth.
Another important trait is the keenness to conduct research before investing. Some people love nothing more than digging into financial statements and crunching numbers, while others might not have the time or inclination to plough through prospectuses and product brochures.
Rule 2: Don’t invest in a product you don’t understand.
Most of the people who write to us seeking financial advice, have investments they don’t understand.
They are likely to know every random feature of their Rs 8,000 cell phone, but will be clueless about their insurance policies that are worth lakhs of rupees. Before you invest, you must fully understand how the product works and how you will gain from it.
There are several products (especially insurance plans) that promise the moon and have complex features. Avoid these sophisticated products if you don’t understand them.
Investing in something that you do not understand is gambling with your money.
Instead of the structured products being sold in the market, the humble PPF can also help build enormous wealth in the long term. Increase the investment by just 1 per cent every year and you will have a comfortable retirement.
…but don’t skew your portfolio in favor of one asset
The above-mentioned investment rule does not imply that you concentrate your investments in one or two asset classes.You may not understand equity, but this should not stop you from investing in equity mutual funds.
As long as you understand that the fund manager will deploy your money in the stock market and your investment will move with the market, it is good enough. There are investors who buy nothing but gold, or invest only in bank deposits.
Some invest only in real estate having been conditioned into believing it is the safest asset. The biggest problem with a concentrated portfolio is that a single crash can make you bite the dust. We saw this happen in 2008 when the equity market crashed. A diversified portfolio cushions the risk and generates stable returns. So, opt for diversification.
Rule 3: Do not invest and forget
Don’t think your work is done after you make an investment. In fact, it has just begun.
You need to monitor and review your investments and take corrective measures if they go off the track. At least once a year, you should subject your portfolio to the financial equivalent of a CT scan. The outcome may not be very palatable, but some tough decisions are needed to keep the portfolio healthy.
The first thing to check in your portfolio is asset allocation. It could have changed because of the market conditions and, perhaps, needs to be re-balanced.
- Consider is the performance of individual investments
For instance, you may have wanted to allocate 60 per cent of the corpus to stocks, 30 per cent to debt and 10 per cent to gold and other investments, but due to a fall in the equity market and rise in gold prices, the portfolio now has 45 per cent in stocks, 40 per cent in debt and 15 per cent in gold.
You need to increase your allocation to equity by buying some more and reduce the investment in debt and gold. The next thing to consider is the performance of individual investments.
- Review portfolio in case of special situations
Experts say you should review your investments once a year. However, some extraordinary circumstances may require you to rejig it even earlier. Here are a few such special situations:
- Marriage
Wedding bells mean new goals, higher expenses and a change in risk profile. Your investments need to be overhauled. If your spouse also works, your investible surplus will go up. Chalk out a combined list of goals and plan your investments to reach them.
- Birth of a child
The entry of a new member in the family means additional responsibilities and expenses. You will add new goals to your list and, therefore, need to change your investment pattern. This may also require you to increase your life insurance cover and establish an emergency medical kitty.
- Salary hike
When your income goes up, your investible surplus rises. Ideally, you should distribute the excess amount across different asset classes in the same proportion as your investment mix. You can increase the SIP amount in your investments. You may also want to add a financial goal to your list.
- Loans
If you have taken a loan, put off some of your investments to account for the EMI outgo. Rejig your investments by putting the non-essential goals on the backburner till the loan is repaid. When you repay a loan, you will have a bigger surplus to deploy.
- Low PE stocks may actually be costlier than their high PE counterparts
This is because many of these low PE stocks may actually be costlier than their high PE counterparts, based on other fundamentals.
A high PE stock could be justified if the company has high growth expectations, strong fundamentals, or has huge projects or investments in the pipeline. A low PE stock, on the other hand, may be so valued because of poor earnings growth, weak fundamentals or lack of further expansion opportunities.
This argument is stronger when it comes to mutual funds. Some investors think mutual funds with low NAVs are cheap. A fund at Rs 25 is not cheaper (or better) than one priced at Rs 250. The low price only means it is newer.
Your returns will depend on how the fund performs, which, in turn, will depend on how the market moves.
Rule 5: Factor in inflation while calculating returns
Inflation affects everyone and its impact on the household budget is widely understood.
However, very few investors understand the impact of inflation on their investments.
This is a mistake because inflation should be factored into every calculation of your financial plan.
Even a modest 5 per cent annual inflation can widen the gap between your nominal and real income to almost 20 per cent in just five years.
- Don’t plan your future based on nominal values
Over 40 years, this difference can widen to over 80 per cent. So, don’t plan your future based on nominal values.
Factor in inflation to know the real value of your income and investments.
The post-tax returns from a bank deposit, which offers 8.5 per cent interest, will not be able to match the rise in prices.
This is why planners don’t recommend low-yield debt investments for the long term. Instead, they advise clients to take at least 15-20 per cent exposure to equities to be able to beat inflation.
- Insurance
Insurance is another area where inflation should be taken into account.
A Rs 1 crore insurance cover seems sufficient right now, but this might change when you factor in inflation.
Even 6 per cent inflation will reduce the purchasing power of Rs 1 crore to Rs 40 lakh in 15 years.
Rule 6: Buy insurance to guard against the unforeseen
No matter how careful you are, an eventuality can play havoc with your finances. It could be a medical emergency that racks up a huge bill or the death of the family’s breadwinner.
The only way to deal with these mishaps is to protect yourself adequately. Insurance is a cost-effective way to safeguard yourself against the unexpected.
In fact, life insurance is one of the most important ingredients of a financial plan. This one instrument secures all your financial goals and aspirations. One should have a cover of at least 5-6 times one’s annual income.
However, this is a rudimentary method and a more accurate calculation must take into account your expenses, current assets and future financial goals. Medical insurance is also very important.
- The rise in cost of healthcare
The rise in cost of healthcare means that even 2-3 days in hospital can cost Rs 50,000-60,000. A medical cover will not prevent illness, but it will allow you to access the best hospital in your city without burning a hole in your wallet.
Take adequate health cover for your family and yourself. If your employer offers you medical insurance, take a top-up plan to enhance it. A personal accident cover is a little known, but crucial, form of insurance.
It covers loss of livelihood due to disability, temporary or permanent.
Life insurance is payable only in case of death and medical insurance covers hospitalisation expenses, but these policies will not pay anything if a person loses a limb in an accident or has to miss work for a long period due to injuries. This is where personal accident insurance will come to his rescue.
…but don’t mix insurance with investment
Buying life insurance as an investment is probably the most common mistake stemming from ignorance. A life plan should be taken merely to secure one’s dependants in case of one’s demise, not as a return bearing investment.
So, a unit-linked insurance plan or a traditional insurance policy will not be able to give you adequate protection since a large chunk of the premium goes as investment.
Instead of these high-premium plans, which combine investment with insurance, buyers should opt for term plans. These are pure protection policies that charge a very low premium for a very high insurance cover.
Term plan premiums are low
For less than Rs 12,000 a year, a 30-year-old non-smoker can buy an insurance cover of Rs 1 crore. If you buy online, the premium is even lower. Term plan premiums are low because there is no investment involved.
These policies don’t pay anything if the policyholder survives the term of the plan.
On the other hand, a ULIP that offers a cover of Rs 1 crore will have a premium of Rs 8-10 lakh, while a traditional plan will cost roughly Rs 12 lakh.
Rule 7: Don’t leave tax planning till end of financial year
It is a perennial problem. Taxpayers wake up in March when their employer sends them a notice seeking proof of their tax-saving investments. In the rush to complete their tax planning before the 31 March deadline, many taxpayers make hasty decisions they regret at leisure.
Unscrupulous insurance agents thrive on this panic. This is the time when they can mis-sell high-commission products without the buyer asking too many questions or examining the product in detail. Who would want to go through the policy features in small print when the premium receipt has to be submitted to the office the next day?
This is a penny wise, pound foolish approach
This is a penny wise, pound foolish approach. If you buy an insurance policy that doesn’t suit you, the entire premium goes waste. To save Rs 2,000-3,000 in tax, you could be throwing away Rs 10,000.
Your tax planning should not be a kneejerk event that happens in March, but a part of your overall financial planning. Instead of packing your entire tax planning into March, spread it across the year and take informed decisions. You should buy an insurance plan only if you need life cover.
Invest in an ELSS fund only if you need to take exposure to stocks. Lock money in the PPF, an NSC or a bank fixed deposit if you want to invest in debt. Take a health insurance plan if you need medical cover, not because you get deduction under Section 80D. The tax benefit is incidental, not the core.
Rule 8: Be prepared for a financial emergency
Will you be able to manage your finances if you lose your job today? Financial planners advise that one should have a buffer fund to take care of a financial emergency. This contingency fund should be large enough to meet at least three months’ worth of household expenses, including loan repayment and insurance premium obligations.
An emergency fund should be easily accessible and its value should not be subject to fluctuations. While an investment in equity funds is fairly liquid, its value can go down when the funds are needed and beat the purpose of having such a corpus. Similarly, a home equity loan pre-supposes an appreciation in the value of property, which may not always happen.
A loan will also push up the EMI, which might be tough when somebody is facing a loss of income. Although credit cards are commonly used for emergency funding, they are useful if you restrict the credit to one month. Otherwise, the cost is prohibitively high.
…but do not keep all of it in cash
While the need for a cash cushion cannot be stressed enough, the problem is that many of us hold much more than is needed for our short-term needs. Whether it is in your pocket or in a savings bank account, you incur costs. For one, the opportunity cost of holding cash is high since you forego the chance to invest it to earn a higher rate of return.
More importantly, the cash in your account will lose value if you take the adverse impact of inflation into account. If adjusted for inflation, the return from a savings bank account will always be in the negative. Then there are the psychological costs of holding cash.
Rule 9: Give precedence to retirement savings
One of the biggest challenges for tomorrow’s retirees is to ensure that they don’t outlive their savings. This is a distinct possibility because of two factors: the rising cost of living and an increase in life expectancy.
However, for many Indians, retirement is not as crucial as saving for their children. Whether it is for their education or marriage, or even to provide them with a comfortable life, children are the biggest motivators of savings in the country.
This can be a problem because your retirement is going to be very different from that of the previous generation.
Rule 10: Learn to cut your losses
Many investors believe that if they select a good investment and time their moves well, it is enough. However, the decision to sell, especially at a loss, is not as easy. Financial experts say that the small investor’s portfolio suffers more due to incorrect decisions that are not rectified in time.
Holding bad investments may be worse than not selecting the right ones. To be a successful investor, you need to have a selling plan in place and book losses if the situation so demands.
Behavioral economists contend that our refusal to sell an investment stems from our aversion to loss. If our investment turns out to be good, we are happy to sell and feel good about the gains. However, booking a loss is painful, so we tend to postpone the regret we feel at having made the wrong decision.
Cleaning up a portfolio calls for rational decision-making
We choose to wait out, ignore, or worse, add more to a poorly performing investment, hoping to average out the cost. Therefore, cleaning up a portfolio is a tough task and calls for rational decision-making.
Low-yield insurance policies, dud stocks and poorly selected mutual funds don’t offer any value to the investor, but there is a deep-rooted aversion to get rid of them. Many of the wrong decisions are taken when everything is looking upbeat.
Those who bought obscure infrastructure stocks at the height of the 2007 euphoria are still holding them, hoping that they will be able to recoup their investment one day. Little do they realize that this is a drag on their portfolio’s overall return.
Had they booked losses in 2008 and shifted the money to any average index-based stock, they would have got something back. It is also important not to throw good money after bad. Don’t book profits on good investments just to plough it back into under-performers. You will only be left with lemons. It is better to ride the winners than pump more money into losers.
REFERENCE – https://www.economictimes.indiatimes.com/10-golden-rules-of-investing-how-to-secure-your-financial-future/your-ability-to-take-risks-determines-the-investments-you-should-opt-for/slideshow/17632888.cms