Investment

Guide to Financial Independence – Investment Plan 1

After you have your emergency fund and have started saving money every month, you need to do a good job of investing your savings. The power of compounding is enormous and the early you get on this gravy train the better. I wanted to cover a good bit of detail on each asset class and so had to split this into 2 posts. This first post will introduce the different asset classes. The next post will cover asset allocation – what, why, when and how – including the thought process behind our decisions. And so, onward into this last part of our guide to financial independence.

Is an Investment Plan really necessary?

Most of us would have seen our parents being extremely conservative. The only investments they would have done would be real estate and gold. What with ease of access to information being difficult to say the least and Harshad Metha scam in 1992, investing in equity would not have been a preferred option. Any money not invested in real estate or gold would have been squirreled away into Fixed deposits or PPF. They would not have had a proper plan on expected returns, is it for a specific goal and so on. But most of them worked for the government and have a reasonable pension to fall back on.

In our current world, where most will not have a pension after retirement, income uncertainty is on the rise and retirement planning is a must a good goal based investment plan is a must. You need to have a target that will keep you on the right path and against which you can measure progress. In some unfortunate situations it might even come to light that you cannot meet your goal(s) with your current plan. Whichever it is having an investment plan is a necessity to ensure your financial journey is consistent with your life goals.

How do you define an investment plan?

Step 1: The 1st step in any investment plan will be to identify your life goals. Pattu has a great post here describing how you can identify your goals & dreams. This is a fairly straight forward step and the post in Freefincal covers all bases.

Step 2: The 2nd step is to identify how much you can invest in total now and ongoing. The post here should get you started towards determining the amount available for investment.

Step 3: Plan an asset allocation and investment against each individual goal. This current and the next posts will discuss the details around this step.

Before you define an investment plan and an asset allocation, you need to understand the options available.

What are the different asset classes?

I will only be discussing the asset classes that I believe are worth investing our time and money in. This is purely my personal opinion. It is subject to change based on new information or change in taxation rules. Just a friendly disclaimer so you know what you are getting before you decide to spend your time.

Equity/Stocks:

First up is equity. This is the heavy lifter in any portfolio and will make the best use of compounding. Investing in equity means to buy shares of companies either directly on exchanges or via Mutual Funds. Investing directly in stocks requires a lot of knowledge on how to read and understand balance sheets, annual reports and assessing company management. I have found the approach suggested by Dr.Vijay Malik as a good starting point. If you are just starting to invest in equity, invest a minimal amount in a couple of companies and follow them regularly. You need to do this until you are comfortable you have enough knowledge to understand the industry and the individual company. You can then choose to invest more. The reason I am suggesting such a conservative approach is because investing in individual stocks is very risky. Remember Satyam? Even the 2008-09 recession wiped out a great deal of investor wealth.

Investing in Mutual Funds is a bit more easy. Pattu has many good posts on his website and you can start with this one. A mutual fund collects money from multiple investors and then buys/sells stocks based on their investment strategy. There are mutual funds which concentrate only on large caps, some only buy mid or small caps and some are diversified between all. There are enough options to confuse you. Read the mutual fund document carefully to ensure that the fund strategy fits in with your personal risk/return and timeline requirements.

Before you pull the trigger on equity, understand that inspite of returns in the last 7 years or so, it remains a risky investment in the short term. I personally would not keep any money I need in the next 3 years in equity. More on this later.

Fixed Income Instruments:

Here again there are multiple options – Savings & Deposits in Banks ; PPF/NSC and similar schemes  and Mutual Funds. The Bank and Post office schemes are the easiest to understand as the value appreciation is purely based on interest received. My personal preferences for long term are PPF and NSC in that order. This is because PPF is EEE from a tax perspective – it means principal, interest earned and redemption at end of scheme are all tax exempt. In NSC only principal can be used as a tax deductible under 80C while interest is taxed.

Liquid mutual funds are a good bet for short to medium term. But these need a bit more time to understand the underlying asset and risk. I am yet to invest in these, though I am considering these as an option for investing our emergency fund.

Real Estate:

Real estate has been one of the most preferred options historically in India. I believe land is a constrained resource and will continue to grow in value. you can buy land, plots, independent houses or apartments. But I do not believe this is a necessary asset class. This is because

  1. You need a good amount of money to start investing. Borrowing to buy real estate is a big NO for me
  2. Returns are taxed unless invested in building a house. This means it is not liquid enough as other asset classes.

Since rental income is very low in India (not more than 3%), using this to generate cash flow is again not advisable.

Commodities:

Gold is one popular example of commodity. You can also invest in other materials like crude oil, metals and so on. I have never researched these as I believe the ordinary investor can use stocks as a proxy. You buy the company that can benefit from price increase or drop of a commodity. The returns will be lower, but the risk is greatly reduced too.

Cash:

Cash is the last, the most liquid and is like a security guard. This prevents unforeseen circumstances from robbing from your other asset classes and throwing spanners into your investment plan. As time goes on will be the smallest asset class in your portfolio. This can be cash in your wallet or in your savings account. Cash is necessary to manage monthly expenses and emergencies. With the advent of credit cards and liquid funds, the % of cash in the portfolio is decreasing. I currently have all of my emergency fund as cash, but might move some of it to liquid funds.

Tax Considerations:

Equity: Only investment in ELSS schemes are tax deductible, but the lock in period is 3 years. All other investments either directly in shares or via mutual funds cannot be claimed as deductibles. However capital gains are not applicable on sales of shares after 1 year from date of buying if transaction tax is paid. This is applicable for Mutual funds too.

Fixed Income Schemes: Investments in PPF, NSC and tax saver fixed deposits are tax deductible. However capital appreciation or interest earned are taxed for most schemes other than PPF.

Real Estate: The captial appreciation is taxed at 20% unless reinvested in a new house or in a government tax saver scheme for 3 years.

The next post will discuss how to build an investment plan using different asset classes. I will also share our investment plan and how we plan to use each asset class.

Which are the asset classes you are already invested in? What is you asset allocation?

2 Comments

  1. The more I read about investing in India, it seems to me that investing there has better prospects than investing in the States. Capital gains especially are taxed even if realized after a year though at a lower rate. The advantage here is the exposure to global companies and efficient markets so I guess it is a balance.

    1. I would say it is skewed towards the US for now. If you are working in the US and looking to retire in India then the exchange rate more than makes up for the lower ROI. If you are looking to retire in the US, inflation is so low that there are multiple ways to achieve a real rate of return (ROI>inflation). In India, equity is the only way to achieve this in the long term and is high risk for short term. In the US, you can even look at dividend investing to achieve this! Or rental income. Cannot even think about this in India :(.
      What I also like about US markets is you get to invest in companies that are leading in innovation – Google, Amazon, Tesla – and index investing is pretty good. And like you have said market efficiency and management governance are much much better than in India. Just look at how volatile Adani stocks were the day Gujarat election results were out!

Leave a Reply