Whose Money Is It Anyway?

Introduction to Personal Finance

•Tax-saving; Email from F/A!

•Circumstances

•Employee Chit-chat

•Call from relationship Manager

•Friendly neighbourhood insurance agent

When does the typical, average, salaried individual start thinking about money, investing, personal finance?

Personal Finance Approaches• Tax-savings first

Buy products or make investments in haste at the end of each FY

• Product-firstSeek out a product for a need without understanding/analyzing the need

• Returns-first

Maniacal obsession over returns without paying heed to long-term and short-term risks

Personal Finance Approaches• Needs first

Thorough evaluation of needs … and wants!

• Product-lastWe do not search for products. We narrow down a type of product and then select one from that type

• Tax-planning incidental

Select a product from the chosen category that saves tax.

Personal Finance Approaches• Tax-savings first

• Product-first

• Returns-first

• Needs first • Products-last• Tax-planning incidental

Goal-based investing

Goal-based investing• List all known ‘needs’ and ‘wants’• Classify them in order of importance• Classify them as per duration• Analyze each need/want. Determine how

much we need to invest• Determine how much we can invest(!)• Decide on an approach• Find suitable investments• Invest• Monitor; Manage – A life long exercise!

First, we need to build a moat!

Caerlaverock  Castle, Scotland. Source: Wikipedia

Random Ramblings

1. Protection against ….• Death of breadwinner(s)

1. Inflation-proof income to manage monthly expenses at least until kids go to a job

2.School fees3.College fees4.Marriage expenses5.Other liabilities

Solution: Life Insurance

Product: Pure Term Life Insurance until retirement

2. Protection against ….• Hospitalization of family members

1.History of illness2.Age of dependents3.College fees4.Typical room rents in neighboring hospitals

Solution: Medical Insurance

Note: Enhance premium annually

3. Protection against ….• Emergency expenditures

1. Monthly expenses x 122. Medical emergencies3.Liabilities

Solution: Rainy day fund

Products: SB account; Online FDs, Liquid funds. No credit cards!

Key: Returns are irrelevant; Taxation is secondary; Ability to replenish

4. Protection against ….• Disability

1.Must if job is not permanent2.Must for professionals and businessmen

Solution: Accident Insurance

Products: Get from general insurer not from bank!

Key: Read policy document before buying

5. Protection against ….• Critical illness?

1.Complex products

2.Better off starting a corpus for medical expenses – treat as a long term goal

Solution: CI insurance

Cash Flow Analysis: Creating a Zero-based budget

• Zero-based budget: “One in which every dollar is assigned a role” – Dave Ramsey

• No money left at the end of the month!

• Live ‘hand to mouth’ because of investing!

• No lump sums allowed!

Zero-based budget

• Step 1: List all sources of income

• Step 2: List all monthly expenses

• Step 3: List all annual/recurring expenses

• Step 4: List present and future liabilities

• Step 5: List present investments (incl EPF)

• Step 6: Determine amount available for investment (incl EPF)

Recurring Expenses

• Insurance premium, school fee, AMC fee etc.

• Returns: irrelevant

• Taxation: Irrelevant

• Instruments: SB acct; RDs; Liquid funds; Arbitrage fund(?) …

Future Expenses: aka financial goals!

• List all expected expenses in future

Expenses before income stops

Expenses after regular income stopsaka ‘Retirement’

Dividing the goal timeline

~ 5 years

Save Invest

Power of non-compounding

Power of compounding does not matter for ~ 5Y or less

Saving vs. Investing

~ 5 years

Saving Investing

Choose not to Worry Inflation

Returns Choose not to worry

Importance of beating Inflation, grows with duration

Importance growsWith duration

Taxation Choose not to worry

Importance growsWith duration

Short-term Goals: determining how much to invest

What is the current Cost ?

Take all expenses into accountAs accurately as possible

Use an inflation of 8-10% (more for a safety margin)

Return = post-tax interest rate of FD or RD

Short-term Goals: selecting instruments

• Focus on nature of taxation:

1)Tax upon maturity/redemption (mutual funds)

2)Tax each financial year (RD/FD)

3)As per slab; with indexation; flat rate;

Prefer: Tax upon redemption with indexation (debt mutual funds)

Note on indexation benefit

• Capital gains = Sale Price – Purchase price

• If the purchase was made 3Y ago, Inflate purchase price using cost inflation index

• (Sale Price – Inflated Purchase Price) Can be negative

• long-term capital losses can be set off against long-term capital gains

Short term capital loss (both in equity or debt fund)

short term capital gain (equity or debt funds)

long term capital gain (debt funds)

long term capital loss (debt funds)

long term capital gains (debt)

long term capital gains in equity mutual funds are tax exempt … for now!

Source: CafeMutual

Offset against

Offset against

Why not have some equity exposure?

Is not 5 years long-term?!

A primer on volatility

Year 1 Year 2 Year 3 Year 4 Year 5

10% 10% 10% 10% 10%

Annual Returns

Compounded Annual Growth RateYear 1 Year 2 Year 3 Year 4 Year 5

10% 10% 10% 10% 10%

5 (1 10%)

(1 10%)

(1 10%)

(1 10%)

(1 10%)

1 [

]

CAGR

10% 10% 10% 10% 10%ArithmeticAverage

5

Geometric Average

Compounded Annual Growth RateYear 1 Year 2 Year 3 Year 4 Year 5

10% 10% 10% 10% 10%

5 (1 10%)

(1 10%)

(1 10%)

(1 10%)

(1 10%)

1 [

]

CAGR

10% 10% 10% 10% 10%ArithmeticAverage

5

Geometric Average

4.17 8.54 10.86 11.54 -9.44 8.53 4.14 2.67 11.25 4.57

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

XYZ Monthly Income Plan Fund

Equity Exposure: 11.5% to 15.1%Cash Exposure: 41% to 85%Rest Bonds

5 year CAGR

Year 1 Year 2 Year 3 Year 4 Year 5

8.53% 4.14% 2.67% 11.25% 4.57%

5 (1 8.53%)

(1 4.14%)

(1 2.67%)

(1 11.25%)

(1 4.57%)

1 [

]

CAGR

6.2%

Assuming no fluctuation from debt component!

Monthly Income Plan Funds

5 year returns: 5.6% to 13.6%