The other day, I was asked for investment advise by a retired couple who, despite having a good understanding of investing, were unable to figure out whether they were on the right track. They had investments in a number of funds, mostly equity. Out of these investments, they had a number of needs. One, they needed a monthly amount regularly to meet household expenses. Two, they needed emergency funds that could be withdrawn at short notice for unforeseen uses. Three, they had some large family-related expenses coming up in about three years. And four, there was the money they would need in the long run to fund their living expenses, which means to fund their monthly expenses far into the future as prices rose and needs changed.
Even though this couple had chosen their funds well, they were having problems understanding whether they were on the right track. What they needed was nothing out of the ordinary. In fact, many others have more complex needs. Even so, it was difficult for them to be confident that their investment portfolio was indeed the right one for the job.
But that wasn’t their fault. Understanding how an investment portfolio maps onto a set of different needs is practically impossible. Some of the needs are contradictory. For example, the short-term income needs need stability while for the long-term nest egg, high returns are more important. Looking at a list of ten or more funds; with SIPs, dividends and withdrawals of varying amount flowing in an out; with different performance and quality levels; and different expectations of risk and returns, it’s impossible to figure out, even roughly whether the portfolio will do the job. All you can do is to look at the overall value of the portfolio and get worried and panicky when it declines.
So what’s the solution? Some sophisticated analytical tool that will give us an insight? No, actually, it’s something that someone in your family probably already practices, or at least used to in the decades gone by. The solution is bags. I had this aunt, who used to have a set of little bags which would close with a string around their necks. When her husband’s salary would arrive, she would divide up the money into heads like vegetables, milk, dhobi etc and put each in a bag.
Curiously, as a principle of budgeting, this is known to most of us but few apply it to financial investments. The old couple above should divide up each requirement and have a separate set of investments marked out for each. The monthly income could be in an MIP fund or a post office monthly income scheme. The emergency funds should probably be in a fixed income fund. The long-term money should be in equity funds and so on.
This enables clear thinking about each goal and the investments that will best meet that goal. For example, if an old couple won’t need a certain amount for a decade, then it should be in an equity fund. Long-term investments should be in equity, regardless of the investor’s age. In fact, the worst thing that can happen to retirees is to run out of savings and the long-term growth of equity is needed to fight the corrosive, compounding effects of long-term inflation.
Another benefit of thinking in terms of separate bags of money is that it gives you a way of managing your reactions to adverse markets. If your income is coming from a post office deposit and your medium term money is in an MIP, then a decline in the markets is easier to handle because you can see clearly that the risk is concentrated in the portfolio where there’s time for recovery. You are not dependent on using total values and total returns as the only available indicators to the health of your portfolio.
This approach may mean a little bit of extra work and clear thinking, but it’s indispensable for managing your savings well. If she had just had one big bag for all the money, then my old aunt would have found it hard to run her household.
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