PLANNING YOUR FINANCES EFFECTIVELY

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Almost every one of us possesses a portfolio of investments, a result of either rational planning or haphazard decisions. Planning and management of finances is vital to our economic well being.

What is Money Management?

Money Management is the process of managing your money, investments, assets and taxes. It is an important aspect in daily life, and an effective management of it is necessary to meet financial goals. From protecting capital, to generating profits and reducing losses, the right decisions play a strong role in financial planning.

The Concept of Time Value of Money

A rupee is not always worth the same. Its worth depreciates over time. The Time Value of Money states that the present worth of money is more that its future worth.  There are several reasons for the same.

·         Individuals generally prefer present consumption to future consumption.

·         Factors like inflation. For example, if Rs 100 could buy five books today, in five years time it would probably fetch only two.

Money could be employed productively to generate returns. For example an investment of Rs.100 today could be invested to grow to (100+r) where r is the rate of return. The concept of compounding underlies Time Value of Money .Compounding is the process of investing money as well as reinvesting the interest that is earned. If Rs 1000 is invested for three years for 10% rate of interest per annum, the power of compounding could be illustrated as below.

First Year Principal at the beginning Rs 1000
Interest for the year Rs 100
(Rs 1,000*10%)
Principal at the end Rs 1,100
Second Year Principal at the beginning Rs 1,100
Interest for the year Rs 110
(Rs 1,000*10%)
Principal at the end Rs 1,210
Third Year Principal at the beginning Rs 1,210
Interest for the year Rs 121
(Rs 1,210*10%)
Principal at the end Rs 1,331

The concept of compounding helps to generate future returns from money invested wisely rather than kept idle.

Dynamics of Asset Classes and their Characteristics

Investments are primarily made in classes of assets which are grouped as per their risk behavior. An asset class is a group of investment or securities exhibiting similar behavior. Primary asset classes are Equity, Fixed Income or Debt and Money Market.Equity represents an ownership stake in a company. Fixed Income or Debt provide a specific rate of interest over a specified period and are relatively safer. Regular interest payments are made and the principal amount is repaid after the specified period. Money market refers to short term investments in government securities. The behaviour and characteristics of different asset classes are mentioned below.

  RETURN RISK LIQUIDITY
EQUITY High High High
DEBT Low Low High
MONEY MARKET Low Low High
PROPERTY(Residential House) Moderate Low Low
LIFE INSURANCE POLICY Moderate Moderate(depending on nature of fund) Average
GOLD and SILVER Moderate Average Average

The World of Equity

Among the various avenues of investment, equity as an asset class generally outperforms the rest in the long run. They have been able to beat inflation and deliver returns. Equity in short term could yield quick losses or profits. Equity class is determined by the performance of the equity market. Stocks of a company are affected by numerous factors. Company specific factors such as performance, earnings and profits play a vital role. Key ratios of a company too affect the performance of equity. Market sentiments, inflation and bank interest rates affect trading of a particular stock. Alternatively investments in equity could also be made through mutual funds, either through a onetime payment option or a systematic investment plan (SIP).

 The Convenience of Systematic Investment Plan

SIP or a Systematic Investment Plan regularly invests a sum of money to buy units of a mutual fund. The returns are based on the principle of rupee-cost averaging,

Benefits

  • An investor buys more units when the price of the unit is low and fewer units when the price is high.
  • Rupee cost averaging, reduces the risk associated with equity
  • It is hassle free with easy modes to transfer money.
  • Disciplined way of investing and inculcates the habit of saving regularly.

Rupee cost averaging illustrated

MONTH AMOUNT INVESTED PRICE PER UNIT OF FUND NO OF UNITS PURCHASED TOTAL VALUE INVESTED
1 5000 10.00 500 5000
2 5000 9.75 512.82 10000
3 5000 9.70 515.46 15000
4 5000 9.95 502.51 20000
5 5000 10.00 500 25000

The average price per unit would be the total value invested divided by the total no of units purchased. This would be Rs 25,000/2503.79 units. The average price per share in the above illustration would be Rs.9.88. It is thus seen that the investor having invested Rs 25,000 has made a total of Rs25,308.

  • Dynamics of Bond Market

A Bond is a debt security, where the issuer promises to pay a specified rate of interest during the term of the bond, and repay the principal (called the face value), on maturity.

Why Invest in Bonds?

Diversification is an important aspect in portfolio management. It is beneficial to invest in bonds, stocks and cash, to spread your risks. Bonds pay an expected stream of payments and are relatively safe and reliable. The coupon rate is the interest rate payable to the bond holder and is fixed for the term of the bond. Bonds are considered to be selling at a premium when the price you pay for a bond is more than its face value.  Bonds are bought and sold in the open market, comprising of security firms and banks.

  • Unit Linked Insurance Plans

ULIP or Unit Linked Insurance Plan is a life insurance policy which comprises of an investment option and a risk cover. It invests directly in the capital market and the risks associated are borne by the investor. They come with a wide range of fund options to suit ones risk appetite and investment objectives. Returns are determined as per the performance of the fund. Switching between fund type to cater to changes in investment and risk appetite is permitted, generally with a fee.

Fund Type Investment areas Risk associated
Equity Funds Invests in the capital market and company stocks Medium to High
Fixed Income and Bond Funds Corporate bonds, government securities and fixed income securities Medium
Cash Funds or Money Market Funds Cash, bank deposits and money market instruments Low
Balanced Funds Combination of equity and fixed income security Medium

The fund options available with Birla Sunlife under their Unit Linked Plans are illustrated below.

Fund Option Asset Allocation Risk Profile
Protector Debt-90%-100%

Equity-0% to 10%

Low
Builder Debt 80% to 90%

Equity 10% to 20%

Low
Enhancer Debt 65% to 80%

Equity 20% to 35%

Medium

 Physical Assets and Property

For many investors an important aspect of their portfolio is investing in property and precious objects. Properties like a residential house prove to be an attractive investment option for the following reasons.

  • The capital appreciations from a residential house are quite satisfactory.
  • Options of loans are available from various financial institutions for purchasing of a property.
  • The interests on loans are permissible for tax deduction.

The main disadvantage of investing in a property is that the price, appreciation and the bargaining capacity are greatly dependent on market demand.

 Precious objects like gold and silver also appeal to many investors.

  • They are highly liquid
  • They possess very low trading commissions
  • They are aesthetically attractive.

As against these advantages investing in gold and silver possess the following disadvantages too

  • They do not provide  regular flow of income
  • They do not provide any tax benefit
  • Possibility of cheating ,hence question of genuineness arises
  • Due to softening of gold and silver prices, they have been unable to beat inflation.

Various other investments in precious objects like diamonds, rubies pearls, paintings and antiques are also chosen by certain affluent investors.

Performance of your Investment Portfolio

Understanding your investment’s performance is vital to financial goals and various financial tools assist in judging this performance.

  • The CAGR or Compounded Annual Growth Rate helps to calculate the growth of principal, if the interest earned is invested back at the same rate.

For example, if Rs 100 is invested at 10% rate of interest per annum, at the end of the first year the return would be Rs 10. In the second year, the interest of 10% would be calculated on Rs 100(the original principal) plus Rs 10(the interest earned), that is 10% of Rs 110 which is Rs 11.The CAGR is an important tool in the calculation of profits from your investments.

  • Net Present Value or NPV is the present value of your investments’ future cash flows, minus your initial investment.

For example if your initial investment of Rs 1000 would give you a future cash flow of Rs 2000 in five years, the present value of Rs 2000 at 9% per year would be Rs 1300. This Rs 1300 is the present value, of Rs 2000 after five years. The net present value would be 1300-1000= Rs.300.This tool as a performance on your investment signifies that a negative NPV is not a worthwhile investment while a positive NPV signifies the worth of your future cash flow.

  • Internal rate of return or IRR is rate at which the initial investment equals the present value of future benefits. It helps to evaluate the financial attractiveness of an investment. In the above example IRR would be the rate that would bring about equality between the initial investment of Rs 1000 and the present value of future cash flow Rs 1300.

Understanding Your Financial Needs-Towards a Better Portfolio Management

The first step towards an effective portfolio is to understand ones financial needs. The essence of financial planning lies in this understanding to make the right choice of assets. Planning for financial goals need to be done keeping in mind various factors.

  • Investment need

It is your financial goal to be achieved, in the years ahead. Such as money for children’s education, marriage, a holiday or retirement.

  • Age

As age progresses, there are lesser earning years than living years. Planning needs to consider for the requirement and financial responsibilities after the earning years.

  • Investment Timeframe

It is the time when the investment is planned to be liquidated, to meet the financial goal. For example, the investment timeframe maybe ten years, to fund a child’s college education.

  • Risk Tolerance

Varying from person to person it is mandatory to understand risk appetite to choose the right mix of asset products. A high growth rate of an investment involves higher risk.

The Right Asset Mix for Your Portfolio

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The concept of financial planning ensures that money is available at the right time to meet financial goals. It is a road map of the investor’s goals. With financial goals and the risk appetite in mind the right distribution of assets among different asset classes is vital. This is called Asset Allocation.

A portfolio should encompass the benefits of the power of compounding, a systematic Investment plan or rupee cost averaging. Stressing on the concept of time value of money, money should not be kept idle as your present savings would not sustain your future. Fixed deposits provide the benefit of compounding.  Investments in assets with high growth options would possess higher risk. Therefore it is recommended to have a healthy mix of Stocks bonds and cash equivalents.

The Magic of Diversification

Different asset classes behave differently under various economic conditions. Diversification among different asset classes protects you from market fluctuations. It is one of the most effective ways to reduce risks in a portfolio.

Phases of Portfolio Management

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A portfolio should minimize your risks and maximize your profits. A periodic evaluation and reassessment of your portfolio is recommended as financial needs and priorities change over time. Determination of the right asset mix and investment strategy is the key to effective money management.

Featured Image: Pexels

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