In the last post we covered the different asset classes and their characteristics. In this post we will see how Ravi and Madhuri went about selecting their asset classes for investment. While the discussion will be specific to them, the process outlined is a generic one and therefore you can follow the same for deciding on your asset classes too.
As we discussed earlier the risk of capital loss and volatility are both higher in equity as compared to other asset classes. Debt will be more stable but obviously has lower returns. As most of the significant goals that the couple have are long term, we need to consider the long term CAGR for these asset classes as an input to our discussions. Debt will give a return between 8-10 % over the next 20 years and Equity between 12 – 15 %. For the purposes of being conservative we will assume the lower of the ranges i.e. 8 % for debt and 12 % for Equity in our calculations.
To illustrate the principle, let us take the marriage goals of their children. As we saw before, the goal is 25 years away and will cost 97 lacs in the year 2040. I will not get into the mathematical details here, but there are simple calculators available which will take these as inputs and give you the annual or monthly investment that you need to do. Search the internet for this, you can select any one that looks comfortable to you. Let us now look at the figures:-
- Annual saving factor for 25 years at 8 % return = 0.0137
- Annual investment needed in Debt = 97 lacs x 0.0137 = 1.33 lacs
- Annual saving factor for 25 years at 12 % return = 0.0075
- Annual investment needed in Equity = 97 lacs x 0.0075 = 0.73 lacs
It is therefore evident that investing in equity will require lower amounts of investment. However, does this mean we should put all of our money into equity? The answer is in the negative. While over a long period of time, the risks in equity reduce considerably, none of us are sure as to what changes will take place to affect the world and therefore the equity markets. We need to invest in debt to form the foundation of our investment plan and then add equity to this for growth.
Why not invest in Debt alone to be safe and sound? Well, Ravi and Madhuri can afford to invest 1.33 lacs per year today towards this goal, but if you take all the other goals then the situation will become untenable. For someone who has enough investment capacity to do this by only investing in debt, that will be an easy choice. However, most of us are really not earning enough or have enough prior resources to have such luxury. Equity investment is therefore a bullet that we need to bite, and we may as well become knowledgeable about it to be able to use it effectively.
What about other asset classes like Real estate? While I believe that you should always own the house you are staying in, Real estate as an investment option is not something that I prefer. The reasons are difficulty in liquidity, changing regulations, the specter of black money in such transactions etc. Gold can be an interesting asset class and Madhuri can invest something in it for children’s marriage. However, for all practical purposes it should not be looked at as an investment.
Based on the above discussions Ravi and Madhuri decided to have Equity and Debt as their primary asset classes for investment. How much to invest and in which combination will form the basis of my next few posts.