VP Chaturvedi, MD, Tata Asset Management, shares some valuable tips on managing your finances intelligently

One of the things all of us notice as we become older is that our financial needs increase. We need to buy a house, educate our children, get them married or plan for retirement. It is also a fact of life that very few of us really plan for these needs early enough; most of us start thinking about them only in our mid-30s or early 40s. It is important to start financial planning early in life, to ensure that one does not get into a worrisome situation later. As the popular saying goes, start saving for the winter while there's still some summer left.

We are all familiar with savings instruments like bank deposits, provident fund, company fixed deposits or, at most, government bonds, but the universe of financial savings instruments is much wider and vaster than most of us know. And, it can provide more significant and profitable avenues to deploy one's long-term savings, provided one goes about it in a scientific and disciplined manner. At a very basic level, to prepare a comprehensive financial plan, an individual needs to ask some basic questions. We have listed these questions here, and attempted to answer them to the best of our ability.

When to save?
Young people have several earning years ahead of them, and often do not think about saving. Remember, the earlier you start saving the more likely it is that you will meet your life's financial goals. Start saving as soon as it is possible and keep it up for a long period of time. Invested properly, these savings will multiply manifold, keep you free of financial worries and provide you with a dignified standard of living in your later, non-earning years.

Tell me the basics
There are mainly two types of financial assets — debt securities and equity securities. Debt securities are fixed yield instruments like bank deposits, company fixed deposits, debt-based mutual funds, bonds, etc.

With the exception of postal savings, the least risky instruments, such as government bonds, virtually always yield less than bank deposits, the more risky company fixed deposits, and the heavily risk-prone non-banking financial company (NBFC) deposits and chit funds, where the risk of default either on payment of the interest or of the principal amount itself, is much higher. Yields on debt instruments depend mainly on the creditworthiness of the lender — the higher the risk, the higher the yield — as well as on the maturity of the instrument — long-dated instruments typically have a higher yield than short-dated instruments. The yield is also linked to inflation; fears of higher inflation in the future would mean that investors ask for higher yields today.

In the case of equity instruments, one ties oneself to the fortunes of the company (or index) whose shares (or derivatives) one buys. Traditionally, yields are in the form of dividends paid from the profits but over the past few decades these have typically very low — in the region of 2 or 3 per cent — mainly because the prices of these equity securities, which are listed in the stock markets, have been moving up, creating higher returns for the investor. But they can also move down and cause losses, and the investor has to bear this risk.

What are the available options?
Let us look a little more closely at the various options available. In the case of debt securities, there are various instruments like fixed deposits (banks and companies), bonds (government and companies) and government securities (state and central). One can buy a mix of these securities or, alternatively, one can invest in a mutual fund that invests in a mix of these instruments on behalf of its clients, to optimise long-term returns.

In the case of equities, there are many listed companies and they must be studied before one invests in them. Here, too, there are mutual funds whose managers study the fundamental performance potential of various companies and then decide to put a combination of these in their funds on behalf of their clients. Each mutual fund house would typically have several funds, offering a combination of debt securities or a combination of equity securities. Hybrid funds have a combination of debt and equity securities.

What is the best investment combination?
There is no one answer; it varies from case to case, based on several parameters like age, family lifecycle, potential future financial liabilities as well as current savings potential. But for those who don't want to get into unnecessary complexities, there's a simple thumb rule. Of the total amount that a person wants to save, 80 minus one's age should be in equity instruments, and the remaining in debt instruments.

This means that at the age of 30, you can invest up to 50 per cent of your savings in shares, derivatives or equity-oriented mutual funds, and the remaining in bank or company deposits, postal savings, bonds and debt-oriented mutual funds. At the age of 50, savings in equity instruments should come down to 30 per cent of savings, while the amount in debt instruments should go up to 70 per cent. This model assumes that as a person ages, his or her responsibilities increase and, correspondingly, the appetite for risk comes down. Consequently, the asset class that has the higher risk — equities — gets a lower allocation.

But this is only indicative, not prescriptive. Your savings profile should depend on your own risk appetite, not what the world thinks it should be. Regardless of age, if you don't have the stomach for risk, you would be better off invested in, say, the Public Provident Fund (PPF), rather than in blue-chip shares or well-performing mutual funds. And, if you don't mind taking a chance for a greater return, you would probably do exactly the opposite, even when you are older.

How do debt funds differ from equity funds?
Debt-oriented funds typically have maturity profiles from a few months to a few years. What this means is that they buy some securities that mature in a few months and others that mature in five to 10 years. Obviously, funds that have a longer maturity have somewhat higher levels of risk. So funds with lower maturity are called liquid funds or short-term bond funds, funds with longer maturity periods are called income funds or bond funds, while those investing in government securities are called gilt funds. Out of the debt fund allocation, a person would be well advised to invest 50 per cent in liquid funds and the rest in bond, income or gilt funds.

The prices of equities move up and down, and these movements are at times extremely volatile. But if a person saves in equities over long periods of time, returns have historically been superior to other financial assets. For example, in January 1991, the benchmark 30-share BSE sensitive index was at a level of approximately 1,000. Over the past 15 years, the index has climbed and in February 2006 it touched a level of 10,000. If somebody had bought Rs 10,000 worth of shares in the same proportion as their weightage in the index in 1991, they would have been worth at least Rs 100,000 in 2006, much more than an investment in any debt instrument could ever have yielded.

A note of caution
One should put only that money which one does not need for at least five years into shares, as losses can happen in the short term. Investors who do not want to save for the long term (around five years) would be well advised to not enter the equity market. In the case of equity-oriented mutual funds, investors would be advised to stick to diversified broad market funds, unless they are equipped to analyse various funds in great detail.

How does one make these investments?
Making deposits in banks, companies or the post office is simple. And investing in shares is a complex process, beyond the scope of this article. But the advent of mutual funds has made investing — in both debt and equities — a very simple process now. Many funds offer their facilities in a number of cities around the country. All you have to do is fill up a form and submit the relevant documents, apart from a cheque for the amount one wants to invest.

The best way to select a fund is to look up names of various fund houses, find a few one feels comfortable about, and look up their record of returns over five years. This is particularly important for equity funds, as one should see how they have performed when the stock market was weak (2001 to 2003) as well as when it was booming (2004 onwards). Investing in too many schemes can be cumbersome, and one should restrict oneself to not more than three fund houses. It is also possible to look up mutual funds on the internet. For example, details of the schemes of the Tata Mutual Fund (TMF) are available on their website www.tatamutualfund.com.

Formula for fixed incomes
The best way for a person on a fixed monthly income to invest in funds is to invest a fixed amount every month, in the proportion allocated between debt and equity funds. This process, if done in a scientific and disciplined manner over at least five years, has been known to benefit investors significantly. Look at it just like a recurring bank deposit, and do not be swayed by the short-term ups and downs of either the equity or bond markets. It is a time-tested approach. The TMF website mentioned above has a calculator that can tell you the returns that you could have actually got on the basis of the past performance of its funds.

When do I sell?
Our opinion is that investing should be done only for the long term, and on the basis of projections about future financial liabilities. As and when these come up, one should encash one's savings proportionately. Most funds are open-ended; if there are any emergencies, you can sell your units and take out your money. Equity markets are prone to sharp movements in the short term, and the performance of the market in the recent past would be reflected in the fund's net asset value (NAV), so it is usually more profitable to sell equity funds when the market is higher, rather than when it is lower. But you must always take care to invest only in open-ended funds, especially if you expect that you may need to withdraw the money in an emergency.

Uploaded on November 6, 2006