30 Dec 2020

Why is goal-based investing better?

There are two ways to invest money:

(a) simply investing whatever is left in your bank account after all the expenses have been taken care of, and
(b) investing with a goal of accumulating a specific amount by a specific date.

There’s a name for (b): it’s called Goal-Based Investing. Goal-based investing seems like more work in the beginning, but if you look at the big picture, it’s actually less work than investing without specific goals in mind.

Plans give us clarity

There’s a saying, “Plans are of little importance, but planning is essential.” The specifics of our plans change over time, and some plans simply become irrelevant. But having a plan gives us the confidence we would never get otherwise.

When we plan, we know in advance how much money we’re roughly going to need, and where that money will come from. Either we’ll know that our investments will give us what we need, and we can sleep peacefully. Or, we’ll know by how much we’ll fall short. This isn’t ideal, but it’s arguably better than falling short and not knowing it.

Asset classes

Financial assets can be divided into 2 categories: volatile and non-volatile. Value of volatile assets fluctuate badly making it hard for anyone to guess what the value of the asset would be on a certain date. Example: shares, gold, oil, etc. Non-volatile assets either retain their value or they almost always move in one direction – upwards. Example: cash in your locker, bank deposits, bonds, etc.

While volatility is annoying, volatile assets are the ones that can retain the money’s purchasing power over time. If you want your money to retain its purchasing power, investing them in something like equity is pretty much the only option you have. If you don’t have sufficient amount of volatile assets, your investment simply keeps losing its purchasing power, like a leaky bucket. If you hold too much of volatile assets, the price you get when you sell will be unpredictable, and that can very well be less than what you really need.

Asset allocation

Goals can help you decide on your desired asset allocation, meaning how much to invest in volatile assets and how much in non-volatile assets. Buying volatile assets such as equity or gold is fairly easy. But you need an exit plan for selling them if you want to avoid excessive capital loss. The exit plan usually is to gradually reduce your exposure to volatile assets until you bring it down to 0.

For a goal that’s 15 years away, I might start with investing 80% in equity and 20% in low volatility fixed income. For a goal that’s 8 years away, I’d probably start with 30 or 40% equity exposure. In both cases, I’d reduce equity exposure gradually over time. By the time I’m spending the money on whatever financial goal I had, my equity exposure would be zero, meaning almost zero volatility.

A framework for decision making

Mostly as a benefit of having a desired asset allocation, goal planning gives us a framework for investment decision making.

Equity investing can be confusing and stressful. If equity valuations suddenly fall, should you buy more equity or not? For how much should you buy equity during the fall? How long will you have to wait before you can see profits from this purchase? It’s not easy for anyone to answer these questions. Same confusion exists on the other side too: if there’s a stock market rally, should you sell some equity? When to sell and how much to sell? Nothing here is obvious or intuitive.

If you have a desired asset allocation that’s optimised for a specific goal date, your asset allocation will give you answers to every such question. Your desired exposure to equity is 40%; there’s a stock market rally, and now your equity is 46% of your portfolio. You sell 6% equity and invest that money in fixed income assets. There’s a stock market crash and your equity portfolio is worth only 32% of your entire portfolio. Sell 8% of fixed income and buy equity (at a lower price).

Stock market almost constantly feeds us fear and greed. In this dark alley, your asset allocation lights the path and gets you through safely. You just have to start with a reasonable plan and stick to it even when the going gets tough.

27 Dec 2020

Nifty Next 50 returns — my ‘risk appreciation exercise’

It’s not hard to find historical annual returns of Nifty 50 (here’s a good one), but I couldn’t find a similar summary for Nifty Next 50. I care about the Next 50 index because Next 50 is the core component of Kuvera’s recommended portfolio, which I also invest in:

Nifty Next 50 is the base of our recommendation with 46% of our equity portfolio recommended to this index. Our diversification through Nifty index, one international fund and one focused fund significantly improve on the return and risk of Nifty Next 50.

Because the data wasn’t readily available, I ended up downloading the daily index data and calculating annual returns myself. 

Annual returns of Nifty 50 and Nifty Next 50 indices

While I was initially annoyed for having to do this myself, I think this was a good exercise. What Nifty Next 50 lost in 2000 and 2001, for example, it has recovered only by the end of 2004! I think creating this table was a good Risk Appreciation Exercise for me. I have a feeling I now have more understanding and respect for the risks involved in share market investing. 12 months ago, I would have simply repeated what I heard from others: if you stay invested in the share market for many years, you’ll be fine. Meaning, staying invested is the only risk mitigation you need.

But imagine investing a large sum in the Nifty Next 50 index by the end of 1999. Three preceding years — 1997, 1998, and 1999 — have given eye-popping returns. Novice investors may not think twice before investing if they see such numbers. The Next 50 index soared by 141% in 2003, and that still wasn’t enough to bring the index back to its 1999 level! Only by the end of 2004 did the index actually catch up. If you made a lump sum investment into Nifty Next 50 by the end of 1999 and wanted the money by the end of 2004, you made next to nothing from the share market. That’s still better than taking the money out before 2004 when you were clearly in the ‘capital loss’ territory.

It still might be possible that if you stay invested for 7 years, you’d end up making a good return. But looking at these scary scenarios help you appreciate the risk better and take risk mitigation strategies (such as having an asset allocation) more seriously.

25 Sept 2020

Can you invest in sectoral funds?

What is a sectoral fund? Sectoral funds invest in equity of companies from a certain industry. For example, Tata Digital India fund invests 93% in the Technology sector; Nippon India Pharma fund invests over 96% in the Healthcare sector. (This is the weightage as on 31 Aug 2020, and can change over time.)

If you ask whether technology companies will continue to make money, the answer is Yes. If you ask whether healthcare companies will continue to make money, the answer is Yes. In fact, the answer would be Yes for most sectors. Does this mean you can invest in any sectoral fund?

The answer, as is often the case, depends on what your investment objectives are. If you are investing for the long-term, say for 10+ years, you are better off investing in funds that will consistently give you returns year after year. That usually means investing in a diversified set of companies across multiple sectors. Index funds are an excellent option; I also like the funds and allocation recommended by Kuvera.

If you know very well about a certain industry and you can reliably predict when an industry will do well, you can buy sectoral funds. But you will have to do active investing where you buy the right funds and the right time and sell them at the right time to hold on to the profits. If you have the skill, time, and interest to do this, sectoral funds are an option. If not, go with diversified funds.

Sectoral funds are, by definition, concentrated portfolios. In investing, concentration means high risk/high reward. You have the potential to make a lot of money, but at the same time you can lose a lot of money too. Understand what this means and decide for yourself if you want to take the risk.

13 Sept 2020

But why is volatility in debt investment bad?

In an earlier blog post, I said this:

The way I invest—and most of us do—is to use the debt portion of the portfolio for stability while using the equity portion to bring in earnings/growth. Taking risks in debt funds for the sake of getting better returns is simply forgetting why you have an equity/debt split to begin with.

In this post, let us think about the rationale behind this principle. Before we start, let me expand on what I meant when I said “the way most of us invest”. The idea here is that:

  1. As our financial goals are approaching, we’ll be moving money from volatile investments such as equity and gold over to debt investments.
  2. By the time we want to spend the money on a financial goal, we’ll only be redeeming debt funds because 100% of the corpus for that goal should now be in debt.

My goal’s asset allocation glide path is designed in such a way that as the goal approaches, money is gradually moved from equity investments over to debt. I use my own asset allocation glide path, but if you use Kuveras goal planning, Kuvera will guide you through its own proprietary glide path. Follow the asset rebalancing advice that they regularly send, and your investments will follow their glide path. (Shameless plug: if you are new to Kuvera, sign up using my referral code JK1P3 to get Kuvera Coins worth ₹100.)

With these assumptions stated, let us look at an example. Let’s say I need 20 lakhs for my son’s college fees that’s due next month. I will have all of this 20 lakhs in debt funds, thanks to the glide path. Let’s say this is a volatile debt fund, and it loses 5% before the due date. Now the debt investment is worth only 19 lakhs! The fund might eventually recover if I stay invested for a few more months, but my son’s college will not wait. I’ll have to scramble to arrange the lost 1 lakh from some other source. This is essentially the reason for choosing a more stable debt investment over a more volatile one.

The natural question that follows is what if your goal is 10 or 15 years away and you’re not really going to spend the money any time soon? Can you invest in riskier debt funds and move them gradually to safer debt funds? You can. But then your glide path becomes complex; your portfolio will have more churn because you are not rebalancing between 2 buckets (equity+gold and debt) but 3 (equity+gold, high risk debt, and low risk debt). If you are okay with more risk, why not just invest in equity for a longer period? Your glide path remains simple and yet you take more risk in the initial days by having a larger allocation to equity+gold.

Investment is a very personal exercise. There are many “best practice” advices, but there is no single rule for how exactly to do it. Think about your desires and preferences and choose a path that’s just right for you.

12 Sept 2020

Are debt mutual funds better than bank fixed deposits?

A friend of mine read my post on debt funds and asked me this question. “If you shouldn’t be optimising your debt portfolio for return, why not just put the money in bank fixed deposits (FDs)? Are there reasons to choose debt mutual funds over bank FDs?”
A very good question. Putting higher returns aside, are there reasons to invest in debt mutual funds rather than investing in FDs?
I can think of the following reasons:
  • Diversification. With an FD, you trust that a certain bank (or a few banks) will be able to repay you. It’s arguably not a huge risk that a bank will go insolvent, but the risk is nonzero. With debt mutual funds, your money is invested in several bonds/CDs/CPs/etc so the risk of any one—or a few—institutions going insolvent is mitigated. You might lose, say 5% of your capital but not 50 or 70%.
  • Convenience. If you were to invest in FDs, you need to decide which bank, for how long, etc at the time of investment. When you buy debt mutual funds, you don’t need to make those decisions. The fund manager makes those decisions for you. You pay the fund manager for this work, of course, through the fund’s expense ratio. But the convenience is worth the money in my view.
  • Income tax. If you have an FD for 10 years, you’ll be paying taxes every year for the accrued interest. With debt funds, you don’t have to worry about taxes until the time you redeem the funds. Also, taxation of long term debt mutual funds is not at slab rate, which can be a big plus for people who are in the highest tax bracket; it’s less of an issue for people with low tax liability.
  • Restrictions imposed by FDs. This is just a combination of convenience and rate of returns. Let’s say you have 10 lakh rupees in 10 FDs: 1 lakh each. You need to withdraw ₹70,000 for some expense. Now you can break one FD and re-deposit the balance ₹30,000, but you’ll lose any unpaid interest for the deposit, including for the ₹30,000 you will be re-depositing. You can maybe ignore the interest loss, but you really have to think and decide how to reinvest this ₹30,000. For example, how long to invest, should this be a single ₹30,000 deposit or a few deposits of lesser amounts, etc. If the same 10 lakhs was in a debt mutual fund, you simply redeem ₹70,000 and that’s the end of the story.