How to use mutual funds in goal planning

Most Indian investors do not have a structured approach to savings and investments. Most people do not have saving target; the amount of money they save depends on their spending habits. Likewise, most people invest in an ad-hoc way. When they have accumulated a sufficiently large amount of savings, they invest it in bank FDs, Post Office small savings schemes, stocks, bonds, mutual funds etc without any specific goal in mind.

Whether we have formal financial plans or not all of us have different financial goals in life. Some goals may be individual or family specific (like foreign vacations, vehicle purchase, home purchase etc), while others are stage of life goals like children’s higher education, children’s marriage, retirement planning etc. Each of these goals, short term, medium term or long term, requires us to have a certain amount of money.

You need to estimate how much money you need for each goal, work backwards to determine how much you should save every month and where to invest in order to meet your goal in the required timeframe.

How much you need to save?

Let us assume your child is 8 years old and you want him / her to study medicine to become a doctor. The current cost of education is around Rs 20 lakhs in private medical colleges. If you factor in 10% education inflation, you need to accumulate around Rs 50 lakhs in 10 years, when your child is ready to college.

Assuming 10% return on investment (ROI) you need to save around Rs 24,000 every month to meet your child’s education goals. If required, you may have to cut down on your discretionary expenses in order to meet this goal.

Saving is not enough, you need to invest

Saving is necessary to meet financial goals, but savings alone will not ensure success in your goals. You need to invest your savings in the right instruments to achieve your goals. Continuing with our earlier example, if you put your savings for your child’s higher education in recurring deposits earning an interest rate of 7% p.a. you will be able to accumulate Rs 40 lakhs in 10 years, Rs 10 lakh short of your goal. One of the most important concepts, which investors must understand in order to make the right investment decisions, is the relationship between risk and return. You cannot get higher returns without taking risks. You should always invest according to your investment needs / time-frame and risk appetite.

Risk / return characteristics of asset classes

Asset class class is the most fundamental element of investments. There are different asset classes like fixed income, equity, gold etc. Fixed income is least risky of all asset classes. Fixed income instruments can either be risk free (e.g. bank FDs, post office small savings schemes etc) or market linked. Risk free fixed income instruments usually give the lowest rates of returns. Equity, on the other hand, is the riskiest asset class but it has the potential to give the highest returns over long investment horizons. Gold, for cultural reasons, is an important asset class in India; many families invest in gold for children’s marriage. The risk profile of gold is somewhere midway between fixed income and equity.

If you had invested Rs 1 lakh in Nifty 50 TRI 10 years back, your money would have grown to Rs 2.66 lakhs (10.3% CAGR) as on 20th November 2019. The same amount of money invested in FD and gold would have grown to Rs 2.09 lakhs (7.6% CAGR) and Rs 1.9 lakhs (6.9% CAGR) respectively (Advisorkhoj Research).

Risk and investment tenure

Risk of a market linked asset is usually related to investment tenure – risk usually goes down over long investment tenures. This is because price volatility is a short term phenomenon and asset prices tend to show mean reversion in the long term, following the long term secular trend. Relationship between risk and tenure has important implications for investment planning. You cannot afford to take too much risk if your goal time-frame is short and you will have to invest accordingly. On the other hand, if your goal time-frame is long, you can invest in riskier assets which may give higher returns on your investment. Even if your investment value goes down in the short term due to volatility, it may recover and grow in value over time. Therefore, it is very important that you need to select the right instruments according to your financial needs; you need to take the optimal amount of risk depending on your needs.

Mutual funds for different needs

Mutual funds offer a wide array of products suited for different investment needs and risk appetites. There are broadly three types of mutual fund schemes based on asset class and risk characteristics.

  • Equity funds, which invest primarily in equity and equity related securities. There are different types of equity funds depending on market capitalization segments orientation (e.g. large cap, mid cap, small cap, multi-cap etc) and investment strategies (e.g. value funds, dividend yield funds, sector or thematic funds) etc.
  • Debt funds, which invest in fixed income securities like money market instruments, Government Bonds (G-Secs), non convertible debentures (NCDs) etc. There are different types of debt funds depending on maturity / duration profiles (e.g. overnight funds, liquid funds, ultra-short duration funds, low duration funds, short duration funds, medium duration funds, long duration funds etc) and credit risk profiles (e.g. Gilt funds, corporate bond funds, credit risk funds, banking and PSU debt funds etc).
  • Hybrid funds, which invest both in fixed income and equity securities. There are different types of hybrid funds based on asset allocation strategies (e.g. aggressive equity oriented hybrid funds, dynamic asset allocation funds, equity savings funds, conservative debt oriented hybrid funds, multi-asset funds, arbitrage funds etc.)

Different types of mutual funds provide solutions for a vast array of investment tenures ranging from a few days (e.g. overnight funds, liquid funds etc) to 10 years or longer (e.g. multi-cap funds, midcap funds etc) and different intermediate term investment tenures in between. In addition, there are solutions oriented mutual funds like retirement fund, children’s fund etc. If you educate yourself about mutual funds or consult a financial advisor, you are likely to find a product that is best suited for your specific needs.

You do not need to have a lot of money to start investing in mutual funds for your financial goals. The minimum subscription amount for one-time (lump sum) investments in most schemes is as low as Rs 5,000/- only. For your long term goals, you can invest through Systematic Investment Plan (SIP) of just Rs 1,000 per instalment (monthly or any other interval chosen by you).

Mutual funds for goal planning

Mutual funds are one of the ideal investment solutions for a wide variety of investment needs and risk appetites. You can use different kinds of mutual funds with different investment objectives to reach your goals. We will look at some common goals and the most suited mutual fund options to invest in for these goals.

  • Retirement Planning:This is usually a long term goal. Different types of diversified equity mutual funds like large cap funds, multi-cap funds, large and midcap funds, midcap funds, small cap funds etc are suitable. Depending on your risk appetite and investment experience, you can also invest in thematic or sector funds. SIP is the best investment mode over long investment tenures since you can benefit from the power of compounding and also take advantage of volatility through Rupee Cost Averaging which may give superior returns.
  • Children’s education and marriage: These are also a long term goal, but their time-frames are usually shorter than retirement planning. Further, parents do not want to take too many risks with their children’s goals. Large cap funds, index funds, hybrid funds (e.g. aggressive equity oriented hybrid funds, dynamic asset allocation funds etc.), gold funds (for children’s marriage) etc. are suitable. Once your goal time-lines are nearer, you may want to switch to debt funds to de-risk your children’s education or marriage related goals.
  • Saving for vacation, vehicle or home purchase in 1 – 2 years: Debt funds like low duration funds, short duration funds etc are suitable for these goals. If your goal time-frame is shorter i.e. less than 1 year, then liquid funds and ultra-short duration funds are more appropriate investment choices. If your goal duration is slightly longer i.e. 3 years or so, then you can invest in long duration debt funds, dynamic bond funds etc which may give higher returns and also get tax benefits
  • Tax Savings: You can invest in mutual fund Equity Linked Savings Scheme (ELSS) to claim deduction from your taxable income and save taxes under Section 80C of Income Tax Act. You can claim deduction of up to Rs 1.5 lakhs u/s 80C by investing in ELSS and save up to Rs 46,800 in taxes. Depending on your financial needs, you can invest for medium (3 to 5 years) or long (more than 5 years) term; longer your investment tenure, higher can be the potential returns
  • Regular cash-flows / income: Mutual fund Systematic Withdrawal Plans (SWP) over long investment tenures are one of the most tax efficient cash-flow solutions for investors. SWPs can be very beneficial for retired investors / senior citizens who need regular cash-flows from their investments for long periods of time. Hybrid funds are good investment options for SWP as they tend to lower downside risks compared to equity funds, at the same time have the potential to generate higher inflation adjusted post tax returns over long tenures

Summary

In this article, we have discussed the importance of goal planning and how to use mutual funds for your various short-term, medium-term and long-term financial goals. One of the biggest challenges that we face is to manage multiple priorities but a thoughtfully constructed investment portfolio linked to goals can ensure success in meeting all your financial objectives. You should discuss with your financial adviser, which mutual fund schemes are best suited for your multiple financial goals.

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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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