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Why financial planning is important for investors

Why financial planning is important for investors

Investor Awareness Initiative-2011, organised by Money Today in collaboration with ICICI Prudential Mutual Fund, will spread awareness about the role of financial planning in helping you achieve your financial goals.

A presentation in progress at the MONEY TODAY-ICICI Prudential Mutual Fund Investor Awareness Initiative 2011 on July 30th in Pune. A presentation in progress at the MONEY TODAY-ICICI Prudential Mutual Fund Investor Awareness Initiative 2011 on July 30th in Pune.
We all have dreams, be it owning a car, a house, child attending a prestigious college or building a healthy retirement corpus. But we seldom pen down these goals and work towards a plan for achieving them. These can be termed as your life goals.

The main objective of the Investor Awareness Initiative-2011, organised by Money Today in collaboration with ICICI Prudential Mutual Fund, is to spread awareness about the role of financial planning in helping you achieve your financial goals.

The speakers at the first such conference held at Pune were Himanshu Pandya, Vice President and Head (Products & Communication), ICICI Prudential AMC and Tanvi Varma, Associate Editor, Money Today.

What is financial planning? Contrary to popular belief, financial planning is not just investing. It is a process. It allows you to manage your finances in such a way that you link it to your goals. Making a standalone investment in a life insurance product means nothing if you do not know the amount of cover you need, or whether the maturity proceeds are adequate, or whether you need a life cover.

The process of financial planning should help you answer three questions. Where you are today, that is, your current personal balance sheet, where do you want to be tomorrow, that is, finances linked to your goals, and what you must do to get there, that is, the asset allocation and investment strategy that will help you achieve your objectives.

Developing a financial plan needs a consideration of various factors. First, your objective or the purpose for which the investments are being made. The time period, too, is critical, since the longer the period of investment, the higher is the ability to absorb risks. Also, one of the most important factors that many of us did not account for earlier is inflation. The level of inflation can deplete your return from investment considerably. Today's expense of Rs 10,000 would be Rs 43,000 in 30 years if the inflation rate stays at 5% per annum.

Mutual funds as a financial planning tool: Mutual funds have managed to constantly deliver financial planning solutions to investors by way of various products that they offer. Contrary to popular belief, mutual funds are not an asset class. They are vehicles that allow you to execute your financial plan.

In terms of the risk-return perspective, not only can you choose funds which are as safe as you want (such as liquid funds), you can also invest in funds that can be as risky as you want (such as sectoral funds). In between there are various types of funds that have different levels of risk. Not only are they cost efficient, they are tax efficient as well.

Investment tools such as systematic investment plans (SIPs) and systematic transfer plans (STPs) are ideal for salaried individuals who want to invest consistently and ride through market volatility. By rightly identifying the risk you are willing to take, your liquidity requirement and your return expectation, you can match a fund to suit your investment objective.

Remember to invest in products you understand, and more important, stick to funds that have an established record. Given below are excerpts from the interaction that investors had with the panelists.

Himanshu Pandya, VP and Head (Products & Communication), ICICI Prudential AMC
Q. What is a Value-averaging Investment Plan (VIP) and how is it different from a Systematic Investment Plan?

Himanshu: VIPs have not received as much attention as systematic investment plans. An SIP lets you invest Rs 1,000 every month, no matter what. A VIP lets you do the same. But in a VIP, if the market falls by 15-20%, the fund house has the freedom to invest more. This means that if the markets fall drastically or continuously, you can increase your investment amount during that phase. The amount can increase to Rs 3,000-5,000 depending on what is indicated in your form. It is a simple tool that allows you to invest more when the markets are down. Similarly, when the markets are rising, it will only debit Rs 1,000. It will also have an annual target in place, which is the maximum amount you want to invest. So, if you achieve this target in 5-7months, it will not debit more.

Q. You (Himanshu) said that one should look at processes rather than managers of a fund. What kind of processes should one look at?

The investment processes for an equity fund has three stages. The first is stock selection, the second is portfolio construction and the third is risk management. What an investor sees is a simple NAV of the portfolio, but how well the portfolio does on a risk-adjusted basis is a function of these processes.

"The pedigree of a fund, in terms of how long it has existed in the Indian market and its track record, is important."
Unfortunately, for a retail investor, it is very difficult to gauge the strength of a fund's processes. You cannot ask an AMC how strong its investment management processes are, which is why financial services and wealth management are businesses of trust, not innovation. This is also why the pedigree of a mutual fund, in terms how long it has existed in the market, and its record, is important. It gives you an indication of the robustness of its investment processes and the risk control mechanisms.

Tanvi: Another thing that you can look at apart from performance is some of the risk-adjusted ratios. Some websites that publish data on mutual funds will also give you ratios on fund performances. They talk about standard deviation, which reflects how much the performance of the fund has actually varied and how volatile it has been. One should look at the beta of the fund or the portfolio, which is the risk of a portfolio compared with the market. For example, a beta of 1 indicates that the fund's NAV has moved with the market. If a fund has a beta of 1.2, it means it bears more risk than the market.

Q. How often should one review goals and adjust portfolios accordingly?

The financial planning process is like a football match for many people. There is the goal, there is the ball and one can beef up the defense or the offense. The goal is to score. But, it's more accurate to say that financial planning is a game where goal posts are constantly changing.

"A quarterly review of a portfolio is good. Once in six months is also fine. But it really depends on how your objectives change."
You not only have to deal with the complications of your own theme, but also with the fact that the goal post itself is very dynamic in nature. The reason for this analogy is simple. The investor has to decide the frequency of review himself. An advisor cannot impose a frequency of review. Typically, it is said that once in a quarter is useful.

But for a long-term goal, a quarterly review may not be required. As an investor, I need to respond to changing economic circumstances and changing personal circumstances. If my goals have changed or if my lifestyle has changed, it is important that I review the plan that is currently set.

Tanvi: Categorise your goals into short, medium and long terms. So, if you are talking about paying off a credit card debt three months from now, you have probably been saving for it from your income. Once you have paid off that debt and you have that income with you, you need to find another avenue for that income. For this you need to sit with your advisor and decide a plan of action. A quarterly review is good. Sometimes, once in six months is fine. But it really depends on how your objectives are changing.

Q. What is the difference between a debt plan and a fixed maturity plan?

An FMP is like a term deposit, wherein you invest money for a period, say one or two years, and want that money back after that period with no question of any capital loss. FMPs have a fixed maturity, meaning you can neither enter or exit in between. When you put your money in a one-year FMP, the fund manager will buy only those securities that mature exactly after a year.

Investors at the event
Investors at the event
Investors at the event
Investors at the event
Investors at the event get their doubts cleared
This means that there is no question of intermittent capital loss or loss of value deterioration. So, an FMP is different from a debt plan in that it's a fixed tenure product and locks the money.

People often think that you can never lose money when investing in debt instruments. There is a possibility of intermittent loss of capital if you select the wrong product. For example, if I have money for one month and if I select an income plan with a maturity of 12 months, I am choosing the wrong product. It is possible that I may lose money in that one month because of the value of the underlying securities.

Q. What is the difference in returns if I invest Rs 60,000 in a systematic transfer plan and Rs 5,000 per month in a systematic investment plan?

An STP is systematic transfer of money from one scheme to another. If you are investing Rs 60,000 in an STP, Rs 5,000 will be transferred into equity every month. In an SIP, you supply Rs 5,000 every month. For instance, if you have Rs 60,000 today and you invest in equity and the price falls, the value of the investment will fall. With an STP you can choose to park this money in a liquid fund and give a mandate where Rs 5,000 is transferred every month into an equity product, thus averaging it. The only difference in returns will be to the tune of the return generated by the original liquid product. Otherwise there will be no difference.

Q. You talked about standard deviation. What is a range that can be considered normal or safe when choosing a fund?

"One should look at a fund's or a portfolio's beta, which is its risk compared with the market, before investing."
Himanshu: Standard deviation is broadly seen as a measure of risk. So, greater the standard deviation of the scheme, the greater is the risk associated with it. There is no fixed benchmark because if the markets are very volatile, a scheme's standard deviation will also be high, as it reflects the volatility in the market. Sectoral funds will typically have a much higher standard deviation and large-cap equity products a lower standard deviation.

Tanvi: The only way you can actually compare standard deviation is probably by selecting a category of funds. For example, if you are looking at equity diversified funds, look at all the funds within that category and identify funds with higher standard deviation, mid-range deviation and low deviation. This will help you understand which funds are volatile. But there is no particular range or a band.

Q. Gold funds and gold ETFs already exist. Now, with silver prices zooming, can we expect products similar to silver ETFs or silver funds?

I head the product function in ICICI Prudential and I can tell you immediately-No. The reason is very simple. Silver is much more voluminous then gold. If you put Rs1 lakh in gold, then not much space is required to store it, while Rs 1 lakh worth of silver weighs about 1.5kg.

The custodian cost is very high for silver and we have a ceiling of 250 basis points that a fund can charge. The second problem is that silver is a corroding metal, unlike gold. Given these problems, it is very difficult to come out with a cost-efficient solution for customers that is profitable for asset management companies as well.