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How mutual funds can be used in financial planning
May 13, 2011

"Riches do not respond to wishes. They respond only to definite plans, backed by definite desires, through constant persistence." - Napoleon Hill

The importance of Financial Planning couldn't have been summed up better than this. To simply put, financial planning is a tool through which you can chalk out definite plans in order to achieve your financial goals thus ensuring you peace of mind at various stages of your life cycle.

All of us have financial goals - be it buying a house, buying a car, getting children married, their education and then our retirement. But, unless we do not assess where we stand in terms of our income, expenses, assets, liabilities, age and risk appetite, all the financial goals would just remain "dreams" and would never turn into a reality.

Today there are several investment avenues; but for you to optimally undertake financial planning (to achieve financial freedom), what is required is combination of various financial products in the respective asset classes - be it equity, debt or gold. However, your asset allocation also needs to be optimally structured for work for you (in the financial plan); or else it would not help you attaining financial freedom.

Strategic Asset Allocation

Barring "most conservative portfolios" which do not hold equities at all, every portfolio should be optimally structure and diversified to hold all asset classes:

  1. Cash - for security and liquidity, so that one can take advantage of opportunities as they arise

  2. Bonds - to help preserve capital and provide a steady income

  3. Stocks - for growing wealth and to help you beat inflation and counter the impact of taxes

  4. Real estate - because of their low correlation with stocks and bonds

  5. Gold - for its ability to be a hedge against the inflation bug and other economic and political uncertainties
Once your asset allocation is optimally structured, the next important action point should be having the right investment avenues / products under each asset class, in order to achieve the financial goals (within the time frame) with comfort.

Among the various investment avenues available today, mutual funds (amongst other investment avenues) are a wealth creating avenue, aiding you achieve your financial goals. Moreover they power your portfolio with diversification benefit. And mind you diversification immensely helps during the turbulence of the capital markets as the jerks (of turbulence) are felt far lesser. The other benefits which you enjoy while investing in mutual funds are:

  • Professional management - Your money is managed by a professional fund manager, hence ascertaining the prospect of the companies is not your headache and portfolio churning (if required) too is taken care by him.

  • Economies of scale -Even though if a mutual fund does engage in high portfolio churning in the race to deliver luring returns, the voluminous trade carried out by it helps to enjoy the economies of large scale and have lower impact on their profitability. But on the other hand if you were to do this by yourself, you may get negatively impacted on the profitability front due to small volume of trades carried out.

  • Lower entry level -With the minimum investment amount in mutual funds being as low as ` 5,000, the encouragement to start small and at the same time take exposure to the fund's portfolio of 20-30 stocks (due to diversification) is also present. Now this is unlike stocks because there with ` 5,000 you can barely buy few quality stocks - and this especially true when valuations are expensive.

  • Innovative plans/services for investors -Today for regular investing in mutual funds (which is much needed to achieve financial goals), AMC (Asset Management Companies) offer innovative plans such as SIP (Systematic Investment Plan) / STP (Systematic Transfer Plan). Also for facilitating withdrawals too (taking care of your cash flow requirements), SWPs (Systematic Withdrawal Plans) are in place, thus enabling you to manage your portfolio from a financial planning perspective too.

  • Liquidity - Unlike direct stock investing where you may encounter a situation where a stock turns illiquid (due to various reasons); in mutual funds you would not face such a situation if the scheme selected by you follows strong investments systems and process. This because the stock selection process helps in eliminating such illiquid stocks. Moreover as an investment avenue, mutual funds per se, especially the open-ended mutual funds offer you the much required liquidity as you can simply buy / sell units at the day's NAV (Net Asset Value) by approaching the fund house directly, or by approaching your mutual fund distributor or even by transacting online.
Hence having assessed the inherent advantages of mutual funds, you can strategise your portfolio with the help of equity funds, debt funds, hybrid funds and gold funds whereby the under-mentioned financial objectives can be catered to.
  • Growth
  • Income
  • Inflation protection
  • Peace of mind and preservation of capital
  • Tax saving
But your financial planner should ideally balance the importance of each of these, while structuring a portfolio. Remember there is no one rule for all in Financial Planning.

While drawing a financial plan you need to cooperate with your financial planner and try to ask yourself the following questions and attempt answering them too in a very honest manner. .

  1. Towards what objective/goal am I investing my money?

    Knowing the objective of investing enables you to select the right options. For example, if you have a long term objective of wealth creation, then going with an equity oriented fund (following a growth style of investing) would be prudent. However if your objective is to maintain short-term fund requirements, you may invest liquid funds or ultra-short term funds.

  2. What is the time horizon?

    Time horizon refers to, when do you want to enjoy the fruits of your investments. Ascertaining this is critical because both, the risk and the reward of investments can vary according to the time horizon. Generally, a longer horizon allows for more aggression in investment. Lesser the time, the more one needs to avoid risk.

  3. What is my risk appetite?

    There is a risk-reward continuum running from cash to bonds to stocks. Returns are commensurate with the risk someone is willing to tolerate. High risks may also eat into your capital. And if there is no income to make up for that lost capital, replacing it would be difficult; which means a more conservative approach needs to be followed. Other considerations could be the present financial situation, estate planning and level of taxation.

    Another important factor is age. As a general rule, the younger one is, the more aggressive someone can afford to be with their investment portfolio. This is because you have more time to recover from any possible setbacks in the value of the portfolio.

Portfolio rebalancing

After building a portfolio having answered the aforementioned questions you cannot afford to sit tight. What is required is portfolio rebalancing. Rebalancing refers to the action of bringing a portfolio of investments that has deviated away from target asset allocation. The goal of rebalancing is to move the current asset allocation back in line to the originally planned asset allocation. Rebalancing is primarily warranted under conditions where the returns have significantly deviated than expected or to stay in line with market conditions. For example, an equity heavy portfolio needs to be restructured in contraction phases where company profits are hit harder and interest rates move up. It could be done by moving a portion of equity holdings to debt instruments. Mutual funds probably allow the easiest window to rebalancing due to their diversity of offerings.

A case would be may help you understand rebalancing better.

Mr X has planned for his son's marriage in 2020, for which the estimated cost in 2020 would be Rs 1.7 crores. In 2010 he is advised to invest Rs 70,000 in equity and Rs 30,000 in Debt assuming an average return of 12% for equity and 5% for debt. The expected value of investments after the end of 1 year would be 78,400 for equity and 31,500 for debt.

However, at the end of 1 year period, the equity markets performed worse than expected at 8% and the debt markets performed better than expected at 14%. Hence, the portfolio value, instead of the planned Rs 109,900 ended up as Rs 109,800. Consequently, the ratio of equity to debt changed from the original 70:30 to 69:31. To rebalance the portfolio, Mr X has to liquidate his debt holdings by Rs 1,260 and invest in equity. However, Mr. X's portfolio value would fall short of Rs 100 when compared with his expected portfolio value. Thus, mutual funds given their diverse categories and their inherent advantages enable you and your financial planner to align the investment goals on the mantra of DIVERSIFICATION + PATIENCE = SUCCESS

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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