“In the business world, the rear view mirror is always clearer than the windshield.” - Warren Buffett (needs no introduction)
The problem with financial planning is that they are based on the observation of rear view mirror. While this is a valid way of predicting future, your planning should not be based solely on past data. Of course, I am not arrogant enough to claim that I can plan for your future but we will discuss few of the important guidelines that your investment plan should have.
Making a well laid plan: Important factors
The most important factor is your objective of the investment you are going to commit. Remember that investing is a long term game, very different from speculation though we tend to confuse these words sometimes. For example, your goal could be to accumulate a sum of 30 lakhs in next 10 years by investing Rs 10,000 a month.
Once you have the goal defined, look for the financial instruments that will give you the required return to achieve your goal. Typically the returns from various instruments are the following:
| Investment Options | Average Returns |
| Equity or equity focused mutual funds | 12%-20% |
| Bonds or bonds focused mutual funds or balanced funds | 8%-14% |
| Government Bonds or pure bond mutual funds, Government Schemes | 6%-12% |
| Bank accounts, FD etc. | 3%-10% |
It is good to invest your money in more than one asset class as well as more than one asset in a particular asset class. The asset class are equity, bonds, and cash. There are few alternatives such as real estate, precious metals, commodities, and others but we will not discuss about these investment in this article.
Finally, you have to decide on how much money to invest in equity, bonds, schemes, and bank deposits. This is also known as asset allocation.
Once you decide on asset allocation, go ahead and invest and watch your assets grow.
Importance of asset allocation
The objective of asset allocation is reducing risk of putting all eggs in one basket. Asset allocation, to a large extent, depends on the time horizon you have in mind and how much risk you can afford to take. Usually younger people have longer time horizon and hence they can invest major portion of their money in equity while older people cannot afford to invest a large amount in equity because of high risk associated with it. Asset allocation helps investors diversify the risk because different asset classes do not experience the same impact because of market fluctuation.
For example, the impact of market fluctuation is highest in equity, less in bonds, and almost nil in bank accounts and Government scheme. Macroeconomic factors such as interest rate and inflation impact bonds and bank accounts more but have less impact on equity.
Understanding risk-return trade off
So now you know equity gives you the maximum returns, what do you do? You invest all in equity, don’t you? Well, we just spoke about diversification and asset allocation. Let’s add further to that.
This is where the concept of risk and reward comes into picture. The reward is higher in equity and obviously risk too. In financial term, risk is defined as the volatility or fluctuation of returns provided by an investment asset. For example, market returns vary dramatically year by year while fixed deposit interest rates do not vary often. Government schemes hardly vary in returns. PPF has been giving the same 8% returns for quite a few years. Hence equity is more risky than bank deposit or PPF. This is the reason investors do not invest all in one asset. Let’s take a look at the risk associated with the different asset classes.
| Investment Options | Risk |
| Equity or equity focused mutual funds | High |
| Bonds or bonds focused mutual funds or balanced funds | Low |
| Government Bonds or pure bond mutual funds, Schemes | Low or none |
| Bank accounts, FD etc. | Low or none |
Finally…
All the points mentioned above, investment plan, asset allocation, concept of risk and reward, are not universal in nature. They have different meaning and criteria for individual investors. For example, a person who has climbed Mount Everest 2 times will find mountaineering less risky than someone who has not ventured in mountains.
Investors should also do some study by going through investment sites and read about companies and earnings before investing in equity. If the investment is going to be in bonds, make sure that you understand the rating of the bond, the returns, and maturity. For bank saving accounts, FD, and schemes, you should check the applicability of interest on returns. As far as possible, do your own study and not go by herds as Warren Buffett mentioned, “Public opinion is no substitute for thought.
The author, Pankaj Priyadrashi is an MBA (finance) from Indian School of Business
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