Financial plan should be the driving factor behind your investments and not the tax planning.
What exactly drives your investment plan and your investment process? You can reasonably assume that in majority of the cases the investment process is essentially driven by the need to save tax. So you buy insurance to save tax under Section 80C as also you buy PPF to save taxes up to your prescribed limit. Your mutual fund investments are largely driven by the need to save taxes by investing in ELSS. Even your decision to invest in a house is driven by the attractive benefits that Section 24 of the Income Tax Act offers on the amount of interest paid out on home loans.
At least, that was the case for Sujit Kumar; whose only investments in the last eight years were the money he had allocated to PF, LIC, tax saving bonds and his apartment also for the tax benefits. For Sujit Kumar it was an eye opener when he sat down with his financial advisor to create a long-term financial plan. That was when Sujit realized that he needed to look at his investment process independent of his annual tax planning exercise. Here is the five-point model that his financial advisor suggested.
1. Invest in equities for wealth creation in the long term
The first thing that the financial advisor told Sujit is to start investing in equities. Of course, direct equities may be too complex and he may not have the time to track them, so the ideal route will be to go through equity mutual funds. Quality equity funds have consistently outperformed the index over a longer time horizon of five years and more. According to his financial advisor, Sujit should adopt a three pronged approach to equity investment. Firstly, prefer equity funds but adopt a phased and systematic approach to get the best of rupee cost averaging. Secondly, take a long term approach of at least five years and don’t get obsessed by short term performance. Lastly, benchmark your fund performance against the index, both in terms of returns and risk.
2. Invest in debt for security and predictability of returns
For Sujit it was news to learn that government debt also carried risk. He had heard of default risk but never knew anything about interest rate risk. The second point that the financial advisor drove home was that unlike equity, debt offered predictability of returns. Just as any portfolio requires growth and long term wealth creation; it also requires a degree of security and predictability of returns. That is offered by debt. Of course, one can opt for direct investment in bonds or adopting the mutual funds route. The financial advisor recommends the debt mutual fund route as he gets the added benefit of capital appreciation in a falling interest rate regime.
3. Invest in gold for a safe haven option in your portfolio
Investing in gold as part of the portfolio plan was something new for Sujit. He had seen his mother buying gold on every Akshaya Trithiya and other auspicious occasions. His financial advisor informed Sujit that gold was the best asset in turbulent economic periods. He also reminded Sujit that gold had been the star performer in the 1980s and between 2008 and 2011 due to the high level of global uncertainty. He recommends that Sujit must maintain an approximately 8% allocation to gold to provide that much-needed stability to his portfolio in turbulent times. After all, with the kind of noises being made by Donald Trump, turbulence may not be too far away.
4. You surely need some liquid investments too
Every portfolio needs liquidity for a variety of reasons. Too little liquidity can be dangerous and too much liquidity can be inefficient. The financial advisor advises Sujit to focus on investing for the sake of liquidity. For example, Sujit must look at moving part of his liquidity needs to liquid mutual funds rather than just keep it in the bank. A liquid mutual fund can earn more than your savings account and the money is almost available on call. Also, most money market funds carry zero risk and they are as good as liquid cash with the added advantage of earning that little bit extra when the money is idle.
5. Back to basics, your investment driver should be your financial plan
Finally, the financial advisor pulled Sujit back to the basic premise of investing. Eventually, your investments must be driven by your broader financial plan than by any tax considerations. You have certain pre-defined financial goals, some existing resources and the capacity to create resources as you go along. Meshing these 3 together forms your financial plan. So do tax considerations fit in? Within your overall financial plan, they surely do! You have decided to allocate a certain sum to equities; you can decide to put part of that money in ELSS to save tax. Similarly, you can divert part of your debt allocation to tax-saving bonds to lock in yields and to get tax benefits. But the driving force behind your investment process should be your financial plan alone.
The writer is founder of Right Horizons