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Financial Planning: Secure your financial future in volatile times

The volatility in markets only underscores the need for taking a financial planning decision based on sound risk as well as time horizon considerations
OVER the last six months, the Indian equity market has seen a huge fall after a long period of spectacular returns. The fall in the equity market indices on one hand, and poor returns in fixed income funds due to rise in interest rates on the other, have led to some confusion among investors. The concerns plaguing the markets are partly global and partly cyclical in nature. The cyclical issues could lead to a temporary slowdown in the pace of growth, but the long-term uptrend will prevail as India is in the midst of a long investment-led growth phase supported by high domestic savings rates and very favourable demographics.

While the long-term picture warrants considerable optimism on equities, investors have been concerned about falling value of their past savings, and confused as to where to put their incremental savings. ULIPs (unit-linked insurance plans), which have garnered a sizeable share of retail savings over the last few years, are also being looked at by many in this light.

There are several ways to approach the question of right investing. Most intuitive, and certainly a popularly held belief, is to put one’s savings or investible surpluses into the asset class that has given best relative return in the recent past, and of course avoid those that have yielded poor returns recently.

So investing viewed thus boils down to looking at recent trends and choosing sometimes equity, sometimes fixed income securities and at other times alternate assets such as real estate, gold and others.

There would be indeed a merit in investing that way if only one can predict when a recently outperforming asset will start yielding poor relative returns. Unfortunately, none of us can predict trend changes consistently and therefore should not subject our financial future purely to our ability to predict changes in trends, also called timing decisions.

Fundamentally, such an approach ignores two essential aspects of sound financial planning —

1) An understanding of how much risk you should be taking and
2) Whether there is something to be gained by not putting everything into just one basket, more popularly called diversification gains.

Both these issues are addressed when one invests as per one’s desirable asset allocation that can be arrived at based on one’s risk bearing ability and investment horizon.

There has been considerable research on the merits of various styles of investing, and there is a particularly useful study for long-term investors. Brinson, Singer and Beebower did an in-depth study of investment returns of a large basket of US pension funds across long periods in time to determine which decisions are more important in investing. The key finding was that 91.5% of the long-term performance was attributable to how a portfolio was allocated among various asset classes — stocks, bonds, cash, and only a small contribution came from stock selection and timing decisions.

The asset allocation decision depends on:

A) Age: A young person will usually have a higher risk bearing ability on one’s savings when compared to an older person; because of lesser responsibilities and a longer investment horizon. For most of us, our age is the single greatest indicator of risk appetite.

B) Investment horizon: People of the same age may not have the same risk appetite if their investment horizons are different. For example; a 30-year-old with a 10-year investment term would have a lower risk appetite when compared to a 30-year-old with a 25-year horizon. Investment return is nothing but the reward for foregoing current consumption and postponing it to some point in future. All things remaining equal, simplifying a bit, the longer you can wait the more you get.

If one has invested as per one’s correct asset allocation after due consideration for the above explained factors, one will worry less about short-term rises and falls in any single asset class.

A ULIP is a financial instrument that, in addition to providing a life cover, enables investors to save in a systematic and disciplined manner as per desired asset allocation to achieve one’s long-term goals. Typically, ULIPs also have flexibility for changing asset allocation, as and when required. For instance, a change in risk appetite with gradual increase in age or dependents. Some ULIPs also have automatic asset allocation as per one’s life stage.

Such a strategy automatically allocates assets based on one’s age bracket and continuously re-balances one’s investments with changing age. These innovative products help passive consumers to meet their long term investment objectives effectively.

The volatility in markets in the recent past only underscores the need for taking a financial planning decision based on sound risk as well as time horizon considerations. For those who have invested in sync with desirable asset allocation, interim volatility does not impede one’s ability to reach one’s goals and the financial future will be more secure.

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