Goals / Investment

Guide to Financial Independence – Investment Plan 2

Financial Balance

In the previous post I discussed the basics of different asset classes. In this I discuss how we have defined our investment plan and why. Read on to know many many secrets!

Now that you know your goals, what you can invest and the basics of different assets, it is time to jump in and build your own investment plan. I have tried to explain the benefits of different asset classes and how they will fit into a complete whole via describing our investment plan. As you will see at the end of the post, the whole is greater than the sum of the parts.

Asset Class Characteristics

There are 3 major characteristics that I consider while choosing the right combination of assets. I have mentioned them below in the order of priority

  1. XIRR: This is very important when I am planning for the long term. It is imperative that I try to beat inflation over the long term. I am ok if I do not beat inflation every year, as long the XIRR over the long term is equal to or more than inflation.
  2. Volatility: This is the variation in the value of the asset. Not the returns, but the value. You can look at equity during the 2008-09 financial crisis. I consider volatility important as I move closer to my goal. Over the long term, XIRR trumps volatility
  3. Tax Implication: I prefer options where I do not need to pay tax when I claim returns. If the initial investment can be tax deductible it is important too, but there are very few options that offer both.

Even though I have mentioned 3 characteristics, not all will be considered every time. You will see why as you read on.

Asset Allocation

Asset allocation is the next most important item that you need to understand. Any plan needs to be diversified between multiple options. This is reduce risk due to fall of any one asset class. Assume you had invest 100 in equity. If it fell 50%, your portfolio value will drop to 50. On the other hand, if you had invested 80 in equity and 20 in PPF, your portfolio value will be 60. If you think something like this will not happen, read this. During the financial crisis, while real estate and equity lost value, instruments like PPF did not loose any value. So asset allocation is extremely important to mitigate risk.

Long Term Investment Plan

I consider any goal outside 8 years to be a long term goal. For the long term, I do not consider volatility as a criteria. This is because as long as the XIRR is good, volatility is not important. I can stomach the portfolio taking a heavy beating safe in the knowledge that it will bounce back and will meet the targets. This means I only look at XIRR and tax implication while deciding the options I want to invest in.

Equity satisfies both criteria and you might say invest 100% in equity towards long term goals. But as discussed earlier, I do not want to keep all my eggs in 1 basket. So for long terms goals, I have decided to invest 80% in equity – a mix of stocks and mutual funds – and 20% in fixed income – which is PF and PPF. Returns from all 3 options are exempt from tax and PF & PPF give me additional benefit of principal being tax deductible too. Win-Win during both investing and redemption.

You might ask why not 100% in equity. This is a dilemma I have been grappling with the last few months. The Mrs. was against 100% in equity, though it was not based on number and just a feeling she had. When we sat down and discussed, we decided that based on our conservative estimate of ROI from equity and high inflation estimates we are still comfortably placed. So we did not want to take on the additional risk that an investment in equity would entail. There are good arguments to be made for both sides and I suggest you go ahead with what you are comfortable with.

There are restrictions around when I can withdraw though. I can liquidate equity as and when required, but PF & PPF have a lot more controls I need to work through. PF can be redeemed only after 55 or retirement and PPF is locked in for 16 years. Loans can be availed on both, though I am strictly against this option. These are meant for truly long terms goals and should not be used earlier than the goal date. I am currently planning for retirement expenses, child education and marriage as part of this plan.

Medium Term Investment Plan

I consider any goal from 5 years to 8 years to be a medium term goal. I do not have any major goals within this timeline. Well, I might have to replace our car, but I am hoping to have it well beyond 10 years of its life. A new goal might come up or a long term goal will move into medium term eventually. For these goals, I will split my investment into 65% equity and remaining 35% in fixed income or debt. As PF & PPF are only for long term, I will use debt mutual funds as a substitute for fixed income options. This is to ensure mote principal protection while sacrificing some returns.

Even within equity, there are different risk classes. Large cap mutual funds and bluechip stocks provide more downside protection when the market falls. Whereas midcap and smallcap funds or stocks tend to be more volatile than the market in general. So the suggested % allocation in equity is just a maximum number if 100% is in large cap. If the risk is higher due to diversification into mid and small caps, the allocation to equity has to be proportionally reduced.

Short Term Investment Plan

I consider any goal that is within 5 years to be a short term goal. This is because I believe equity is very risky for this time period. A bad market crash can take 2 or 3 years to recover and I do not want to risk that volatility for short term goals. As a goal moves into the short term, I will change the asset allocation for that as 20% or lesser in equity and remaining in debt mutual funds. The allocation might be higher depending on the importance of the goal. If I can defer the goal by a year, I might have 40% in equity, but that would be the maximum limit for me personally.

The investment in equity would be purely in large cap or bluechip stocks. Again the priority is principal protection while balancing it out with ROI. I will change this allocation every year so that when we at 2 years to the goal, equity allocation is 0%. As we move even closer < 1 year, I would personally move money out of debt mutual funds into FD. This is a personal bias since I have not used debt mutual funds until now and might change in future as I start using them.

The above is also based on the assumption I will be earning during these years. During retirement I would prefer to have at least 3 years of expense as an emergency fund instead of the rough 6-8 months that we have now. This is again just a rough plan for now and I will evaluate as we move to within 3 years of our retirement.

Summary

  1. Chasing the highest possible returns is not always the best strategy. Identify the returns you need to achieve your goals. As long as your portfolio can meet this target you will successfully meet your goal.
  2. Understand that risks are not the same for all options in the same asset class. Large cap stocks are far less riskier and give much better downside protection than mid/small cap stocks
  3. Understand how income tax will affect your returns. Selling a stock or equity mutual fund within 1 year will incur income tax. For debt mutual funds this horizon is 3 years.
  4. Sometimes principal protection is more important than returns. For the very short term, fixed deposits are better than other options.

I will try to get an excel based calculator out this week to help with calculating investment for each goal.

Do you agree with the asset allocation suggested for each investment plan? How would you do it? Do share your thoughts in the comments so all of us can discuss and learn.

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6 Comments

  1. Great in depth look at different asset classes. I am definitely in favor of investing as much as possible in PPF and PF. In my case, I am definitely going all out 100% stock allocation with a total stock market index fund from Vanguard. I believe that even though there might be some downside in case of a market correction, I am young enough to be able to afford such a correction before I am financially free. In fact, when such a correction does happen, equities would be on sale! 🙂

    1. Wish you a happy new year! I did consider going all in into equities. But that is a risk i could not stomach and decided to go with a 80-20 split. But managing the asset allocation is going to be a minor problem, since PF & PPF are not liquid and I cannot move funds in or out as and when I need to. I am ok with this as at least at the initial point of investment I will be able to diversify. I will need to look at some debt funds in case I want to balance my asset allocation of existing portfolio. This is something where I might take the same road as you and stick to the original asset through ups and downs, specially due to income tax considerations.
      Do you have a plan to change the asset allocation as you move closer to your FI date?

      1. Happy new year to you too! I worked very briefly in India so I didn’t quite spend enough time understanding all the available instruments of investments there. I am reading a book now by Manoj Arora called “From The Rat Race to Financial Freedom” or something of that sort. I understand how PPF and PF work and I think they are great hedges against the risk of equities and one should surely invest accordingly in those instruments. Are you going to be looking at any specific debt based instruments to balance your asset allocation? At this point I do have some bonds but I believe they are less than 2-3% of my total portfolio which is not very much at all. I do have significant amount of cash in a fixed interest deposit account which doesn’t give me spectacular returns but that is my peace of mind. Also in case of a market correction I am hoping to break the fixed interest account and put the money into the market so as to buy equities at a discount.

        To be honest I don’t really have a set date for FI. I am hoping to be there by 35 but due to my visa status in the US I don’t really have a concrete plan and that makes things very interesting to say the least. I do want to have a more balanced allocation when I hit FI so that I don’t take a deep hit when the market corrects but I don’t know now what that is going to be. Just like you I have just completed one year of my way towards FI. I am guessing at some point when it is a little clearer of whether I am going to be in the US or not for the near long term, I will have to sit down and hash out a plan which would make things a little bit clearer.

        1. For now, PF & PPF will total to 20% of my monthly investment and I am happy with that allocation. So will not be looking at other debt based options. I have invested in a short term debt mutual fund to sort of test the waters and learn a bit more. But this is a one time investment until the day when my savings demand more investments into debt. I did read about the FD and you planning to use it to invest when the equity market falls. Slipped from my thoughts I guess.
          Yes, the visa situation is a pain in the back. Should be causing all sorts of dilemmas. My guess is you want to stay in the US for some time. Hope the visa piece work out! Best of luck!
          On another note, isn’t going all in into equities a lot of risk considering the visa situation. Not an opinion, just want to understand your thought process. Do you have a fall back plan if the worst case scenario happens?

          1. I am probably carrying quite a lot of risk with mostly 100% equities and also dabbling a little in cryptocurrencies. However, I am in it for the long run. In the long run 100% equities will surely pay off. I am not thinking of retiring before 35 which is still 5 years away. Even if my visa situation doesn’t pan out, the money can stay invested and grow until I want to withdraw. All of it is post tax money except the amount in my tax advantaged account.

          2. Agree. Even with the associated volatility, long term return from equity are still good. I am also looking at portfolio re-balancing to maintain asset allocation – if this is something I will do frequently or only when the goal moves to within 5 years. Will share my thoughts on this via a post soon. Still not sure which side of the fence I will be on.

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