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How to become an expert mutual fund investor: Avoid hitting bumps

This is the fourth in our seven-part series where we share all that you need to know to make profitable mutual fund investments.

How to become an expert mutual fund investor: Avoid hitting bumps

While we may have a never-ending list of needs and wants, a few of them are also time-sensitive. So, an essential part of financial planning is to categorise your goals on the basis of negotiability. Just think - would you want to delay your kid's enrollment in school because of a shortage of funds? Similarly, think of retirement. If your employer policy says you can work till 60 years of age, it is cast in stone. You cannot bargain here to work for some additional years to be retirement-ready. In contrast, other financial goals such as buying a house, car or going on that chilling vacation can wait.

So, despite the entire goal planning, why do you need to prepare extra notes for your non-negotiable goals? The answer lies in understanding the inherent risks of long-term financial planning - the what-ifs that can derail your plans. What if you earn lesser returns than you had forecast? What if the market hits a rough patch when you need to redeem the money? People with their target date falling in March 2020 (when the stock market went through a free fall on account of COVID-19) must have seen even their most well laid-out plans going off the mark at the eleventh hour. It is like hitting a speed bump on a highway and the only way to make up for the lost momentum is more time. Unfortunately, time is the only thing that you can't afford with your non-negotiable goals. Things like this can happen because the stock market is unpredictable. While it is a no-brainer that equity investing is reasonably rewarding in the long term, no statistical model can tell you with certainty the state of the market at the exact moment when you will need the money.

So, how would you make investments for such goals volatility-proof? The solution is simple. Build safety valves or buffers to provide extra assurance while planning for them. Here is what you should do:

  • Assume a lower rate of return while calculating your SIP amount
  • Reduce a year or two from your actual time horizon

Let's take an example.

Suppose you would require Rs 20 lakh after 10 years to pay the college fees of your child. In the normal course, you assume a rate of return of 12 per cent from your equity investments. So, you decide to save Rs 9,000 per month. However, this forecast can go haywire if these 10 years end up in the middle of a vicious bear phase.

To protect your plan from such vagaries, you will have to save more to build a cushion. Prune down your return expectations from 12 per cent to, say, 10.5 per cent and your investment horizon by, say, one year. With these fresh inputs, you now have to shell out Rs 11,500 per month to accumulate Rs 20 lakh after 10 years. If things pan out as per the plan, you will end up amassing Rs 25.5 lakh, i.e., some extra funds as a bonus. But if the market indeed takes a U-turn, you will have a safety net of Rs 5.5 lakh (25.5 lakh minus 20 lakh) or stomach for a fall of around 28 per cent to guard your plan against going out of order and your body from sleep deprivation.

Also in 'How to become an expert mutual fund investor' series:

Part 1: Know thyself

Part 2: Begin with the end in mind

Part 3: Balance is the key

Part 5: Don't forget the reverse gear

Part 6: Cherry-picking funds

Part 7: Be a sage