ByRanjeet S Mudholkar
India is a nation with one of the highest domestic saving rates in the world. The savings have been in the region of 25 per cent of GDP in the last few years and are predominantly absorbed by real estate and physical assets. The remaining come under the category of financial savings and is distributed among different investment options: out of financial behavior, proclivity or simply out of compulsion.
Financial Planning gives the choice of investment options which best suits a particular situation or phase as per the identified financial goals at the same time taking risk profile into consideration. It is essential as part of financial planning process to assess and respect a client's basic risk profile and create a financial plan linking a client's risk profile to his/her financial goals.
Here we first distinguish between an "investment option" and "investment decision". The former is a broad category of investment classes such as equities, debt, fixed deposits, real estate and precious metals. The latter is either one or more transactions of acquiring as well as disposing assets in an investment class. Obviously, investment option is a broader category, chosen after much deliberation and analysis of individual factors of suitability to goals, risk aptitude, risk capacity, return expectation, etc. It involves strategy and planning. Investment decisions on the other hand are means to actualize investment options. They can vary at times from being analytical and well thought of to being purely on impulse.
The other differentiation is between a 'wise' investment option and a 'right' one. The 'wise' option may not always prove to be 'right' in the short to medium term, while an investment option which comes out to be 'right' may not prima facie be 'wise'. The so-called right investment would be a result of so many factors: general market conditions related to the asset class, interest rate scenario and economic conditions of the time. The investment option chosen at the peak of the cycle, e.g. in equities at the height of the equity bull run, in long dated bonds and gilts at the bottom of the interest rate cycle, in long term locked-in fixed deposits of banks and corporate in a rising interest rate cycle, may come out later as 'not right'.
But such option chosen may not be entirely 'unwise', as the conditions stated above may exist simultaneously in the system and it would be equally ill-advised not to invest in any asset class. This is particularly emphasized as we cannot decide when the peak/bottom of the market/cycle is near. For instance equity markets can be in bullish mode for a painfully longer time after a client has been advised to switch to or remain in cash. So, the post-facto wisdom usually determines if an investment option chosen was right.
So, what determines a wise investment option? Financial planning answers this in more ways than one. The financial planning process of investing is goal-based after carefully determining "asset allocation" relative to the basic risk profile, optimum risk capacity of the individual in a particular life stage. This asset allocation in essence decides the right proportion of exposure to various asset classes. This diversifies a lot of risk in the system while targeting an "optimal" return which helps us in achieving our financial goals. It is underlined that "optimal" return may not be the best return in the system. It should be good enough that the envisaged financial goals are achieved. The same is illustrated in the table below for a 35 year old individual having one child. (See table here)
As a general rule for bifurcation of net after tax income, if one is able to ensure that 1/3rd of the income goes towards expenses while 1/3rd goes towards debt repayment and the remaining 1/3rd is invested towards the achievement of future financial goals, then one may stay assured that there are lesser chances of times of financial hardships in one's life.
Taxation is another area which determines whether the selected investment option is wise or not. Different investment options have different tax efficiency and thus tax efficiency is an important factor in investment decision making. If one has taken a housing loan then he/she is eligible for deduction of Rs. 150,000 from the taxable income for the self occupied property while there is no limit is the property is let out on rent. The principal being repaid can be claimed under section 80 C of Indian Income Tax Act. Public Provident Fund is also a tax efficient investment option for the long term due to its EEE ( Exempt Exempt Exempt ). The real tax adjusted return from assets, a return which after paying resultant taxes beats the inflation during the period is also the crux for deciding on investment options. The size and flow of savings as well as accumulated corpus is modified suitably in stages as we approach individual goals. Near the goal, capital protection assumes more importance than capital appreciation and therefore requires subtle realignments at various stages leading to a long-term goal realization. The liquidity aspect, the costs and the tax efficiency of transactions through various stages of goal-based investing decide in favor of such wisely chosen investment option to be right.
The financial planning process and investing pattern as discussed above rationalizes investment decisions and addresses behavior asymmetry characterized by fear and greed. The investment discipline imposed by financial goals sobers impulses induced by market vagaries. The optimally arrived at asset allocation pursuant to a carefully analyzed financial situation and risk profile of an individual by a financial planner, preferably a Certified Financial Planner or CFP professional, sets the rule for the wise and the right exposure to various investment options in the asset portfolio.
Ranjeet S Mudholkar, is Vice Chairman and Chief Executive Officer, Financial Planning Standards Board India (FPSB India). The views expressed here are personal, and do not necessarily represent that of the organization.
Updated Date: Dec 21, 2014 03:21:22 IST