Most people start thinking about retirement when they breach 35 and get serious about retirement planning when they hit 40. Most of them don’t have much idea about how much they need for retirement. Most are fixated to a randomly large number say, 2 crores or 5 crores. When they don’t know how much they need for retirement, it is difficult to start saving for it.
Balance sheet of most 35-40 year olds I advise follows a similar pattern. They have purchased a house on debt. They have most of their investments in debt products i.e. fixed deposits, PPF and EPF. It is better not to discuss their insurance portfolio. They have 3-4 traditional life insurance plans, which offer them GUARANTEED LOW investment returns and negligible insurance. They have a minor portion, if any, of their assets in equities.
The good part of such portfolios is they have already purchased a house. It does give a sense of financial comfort and security to the family. The bad part is that they have invested poorly otherwise. The portfolio (excluding real estate) is almost entirely debt with negligible exposure to equities.
Personal finance is simple. Purchase a home to stay in. Invest in equity (equity heavy portfolio) for long term goals. Invest in debt for short term goals. Have an emergency corpus. Purchase adequate health and life insurance cover.
Quite surprisingly, most people I talk to have got only the first part (purchase of a house) right. They fall short on most other aspects. If you want to know how much you need for retirement, please read this post. I ask them to have an equity heavy portfolio for their retirement since the retirement is at least 15-20 years away. These are common excuses I get.
- After EMI, there is hardly anything left to invest.
- I will start investing after repaying the loan. At that time, I will invest more and compensate.
- Equity investments are too risky. I am ok with low guaranteed returns.
Well, it requires some serious convincing to set them on right path. If you fall in the same category, here is what you can do.
1. Start Investing Early. Don’t Underestimate the Power of Compounding
By starting early, you can get the maximum benefits of compounding.
“Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t pays it”. — Albert Einstein.
With compounding, time matters more than the amount that you invest. And compounding is no rocket science. Everyone knows about it. However, not many realize its full potential.
Let’s assume the equity funds offer a return of 12% p.a. over the long term. Even if you invest Rs 2,000 per month for 30 years, you will end up with ~ Rs 70.5 lacs at the time of 30 years. However, if you start 5 years late, an investment of Rs 2,000 per month will only grow to ~ Rs 38 lacs in the remaining 25 years.
If you were to reach the same value of Rs 70 lacs in 25 years, you will have to invest Rs 3,720 per month. For the delay in investment by merely 5 years, you have to almost double your investment per month.
You can see the kind of impact Rs 2,000 per month can make. You cannot keep waiting to repay your loan completely before getting serious about investments. If you are 35 and have another 15 years on your home loan, you will be 50 by the time you repay your home loan. Your risk appetite would have gone down considerably by that time.
2. Rate of Return and the Amount Invested Is Important Too
This is best explained with the help of an illustration:
| S.No. | Monthly Investment | Annual Return | Time (Years) | End Amount |
| 1 | 2000 | 12% | 30 | 70,59,828 |
| 2 | 2000 | 12% | 20 | 19,98,296 |
| 3 | 2000 | 6% | 30 | 20,19,075 |
| 4 | 2000 | 6% | 20 | 9,28,702 |
| 5 | 5000 | 12% | 30 | 1,76,49,569 |
| 6 | 5000 | 12% | 20 | 49,95,740 |
| 7 | 5000 | 6% | 30 | 50,47,688 |
| 8 | 5000 | 6% | 20 | 23,21,755 |
So, apart from time in the market, rate of return matters too. So, you need to pick up the right investment products too. Moreover, avoiding a bad investment product is as important as picking up a good product.
There are two sure shot ways of not winning a football match viz. by not scoring goals and by scoring self-goals. Scoring goals may require help from various quarters (economy, choice of investment instrument etc). However, do not score self-goals at the least. Purchasing traditional life insurance plans (endowment plans, money back plans and the ilk) is like scoring a self-goal. If you are lucky, you will get returns of 4-6%. You can see from the above table what you stand to lose if you settle for low return products.
I advise clients not to mix insurance and investment.
You can argue equity investments are risky. Yes, the returns are not guaranteed. However, if you invest in a disciplined manner over the long term, the risk reduces significantly. Settling for poor long term returns is a far greater risk.
3. Diversify Your Investments and Get the Asset Allocation Right
Having a 100% equity portfolio is an equally stupid idea. You need to get the asset allocation right. For instance, even if the goal is 20 years, the portfolio should be equity heavy to start with and allocation should move towards debt products as you approach your goal.
You need to diversify your investments so that underperformance in one asset class can be compensated by good performance of other asset class. Most people anyways have a significant portion in real estate due to purchase of house early on in their careers. Get a healthy mix of equity and debt investments too.
4. You Need Minor Psychological Adjustments
This is useful for those who complain that they have nothing left to invest at the end of the month. Most of us look at our monthly cash flows as
Income – Expense = Investments
So, you invest what is left after taking care of your expenses.
You merely need to change the equation to
Income – Investment = Expenses
Rather than investing what is left after spending, spend what is left after investing.
You can argue that you can’t change the cash flow reality through mathematical jugglery. I think you can but with some psychological adjustments.
As part of my financial planning exercise with my clients, I help them analyze their cash flows too. I ask them to break down their expenses into discretionary and non-discretionary expenses. Non-discretionary expenses are those that cannot be cut e.g. children school and tuition fees, medical expenses, loan EMIs etc. However, there is another category of expenses called discretionary expenses which can be easily reduced e.g. dinner outings, excessive shopping etc. To their surprise, it comes out that they are spending heavily on discretionary items too. By cutting on such expenses gradually, you can easily generate free cash to invest.
You can still argue that money is merely a means to an end. And you do not want to compromise on the quality of life. Well, the quality of life does not go down if you have three family dinner outings per month instead of five. Even if it does, it is a choice that you need to make.
Do you want to enjoy now and compromise in the later years of your life OR do you want to be disciplined now, delay gratification and enjoy later? What would you choose?