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Goal-Driven Investing

When you're investing towards a target, there are a lot of factors like inflation that you should take into consideration...

Once they start investing seriously, most savers start to think about specific goals and targets. Here are some typical goals that savers might have. In three years, I'll need Rs 10 lakh to make the down payment for a house. From 2015 to 2018, I'll need about Rs 3 lakh a year to pay for my daughter's higher education. Next year, I'd like to take my family for a foreign vacation that will cost Rs 5 lakh. As soon as possible, I should have one-years' worth of salary in my bank as an emergency fund. And so on. 'I want to make as much money as I can' is not a target. It's still something that you can work on, but it's not a target in the sense I'm talking about.

Each of these goals has two components--a time-frame over which it has to be achieved, and an amount of money. From this point onwards, it seems like a simple matter to calculate what needs to be done. If you can assume a rate of return, and know some basic arithmetic, you can figure out how much needs to be invested and how much the returns must be for the target to be reached.

However, there are some ifs and buts, as they always are. Unless these are taken into account, the end-result may not be as happy as the calculations indicate. One of the common pitfalls for such calculations is inflation. This is surprising since inflation is so much in the news but most if us fail to appreciate the huge impact that inflation can have over the very long-term. The problem is that assuming a likely rate of return and a likely rate of inflation introduces two independent compounding variables in the calculations. If your estimates are off in different directions on each, it can lead your calculations haywire.

And given that human beings (specially human beings who invest!) are inherently optimistic creatures, they are very likely to underestimate inflation and over-estimate returns. But there's an neat way around this problem. The trick is to appreciate that inflation and investment returns are NOT independent variables. Generally speaking, most asset types can reasonably be expected to generate returns that are inflation + n%, and the range of over which n is likely to vary is much smaller than that of total returns.

Even for something as stable as bank fixed deposits, you'd be hard-pressed to estimate returns over the next ten years. However, you can be pretty much be sure that the returns will be about the same as the inflation rate, perhaps a per cent lower. This makes it much easier to to plan for a estimate real, inflation-adjusted long-term target. Basically, you can just estimate that your returns from an FD will be zero and you will just get your money back.

This works for equity too. It's not as precise, obviously but you can assume that your real equity returns will be about 5 per cent and you will be a lot less wrong in planning your target estimating inflation and returns separately.

So much for inflation. However, do appreciate the fact that this is not a trick of calculation. All returns are, in a manner of speaking, indexed to inflation in some way or another, even in equity investing. Some companies grow faster and some grow slower, but inflation is built into all the numbers that make up that growth. It is genuinely a more accurate method to predict returns as something +/- inflation rather than make independent predictions for both returns and inflation.

There are a number of other things that you need to take care of if you'd like to invest towards a target. Your approach would be different depending on whether the time-frame is negotiable, whether the amount is negotiable. You would also need to change the asset type in which you are investing depending on the time-frame. I'll write about these in a future installment