Our friend, Chanchal Kumar, has many things he wants to achieve in life – buy a home in three years, pay for the foreign education of his two children and save for a comfortable retirement. He has done some reading and started saving for his retirement using a well-diversified portfolio. For buying a house, he has kept aside Rs 9 lakh in a bank fixed deposit. And now to save for his children’s education, he is thinking of buying some safe investments since he does not want to take a risk with his children’s future. Does his plan sound right to you?
This is a common style of planning for many people. They create separate savings pools for each of their goals. If they are sophisticated or advised by a good financial advisor, then each of the pools will have proper asset allocation to meet the specific goal it has for itself. Is that the best approach?
The benefit of separate savings pools is that there is a sense of clarity. Each pool represents your efforts towards a specific goal. The emotional motivation is stronger as each of the goals is real and meaningful to you.
The downsides are many more. When you separate your savings into multiple pools, you face many challenges. The biggest one is your ability to do a proper asset allocation. Let us take the case of the three goals of Chanchal Kumar.
The table below shows the monthly savings needed to secure each goal. You can estimate the savings required for any goal by using the online tool made available at gulaq.com.
Chanchal Kumar needs to invest for Goal 1 (buying a home) in the safest way possible, like the Gear 1 investment that we described in the previous chapter. But if he were to invest in a common pool for the three goals, then the corpus available for the three goals could allow him to follow higher risk and higher return strategies without the danger of falling short of the money required for the goals. Specifically, for these three goals, he would require a monthly saving of Rs 48,993 or 44 per cent less than the separate goals.
The first reason is that the savings are spread over a longer period. Early in your life, you will have many goals that you need to save for, so if you start saving for all the goals, you will need a large amount of savings, and as you grow older and accomplish some of your goals, the savings required will decline steadily. This will be the inverse of your earning power, which will continue to increase over the years as you become more established in your work. The other reason is that the risk of missing your target in a group of goals is lower than the risk of missing your target in any one goal.
Let us imagine that you have to buy three things – a jacket, shoes and a suitcase. Let us say that the jacket costs Rs 4,000–5,000, the shoes cost Rs 3,000–4,000 and the suitcase costs Rs 5,000–7,000. Now if you carried enough money for each item, you would need to carry Rs 16,000. However, if you believed that not everything you want to buy will be the most expensive in the range you evaluate, then you need to carry only Rs 15,000 – on average, the three things will cost only Rs 14,000 and you have more than that.
The second challenge is of management. Chanchal Kumar has to manage three separate pools of investments, allocate money to each of the pools every month and track the performance of each pool.
This is three times more time-consuming than having a single pool. And finally, the challenge of deciding where to withdraw from for every contingency is much harder. Let’s say Chanchal Kumar has an urgent expense where he needs to withdraw Rs 1,00,000 from his savings. Which of these investment pools will he use? Or conversely, let us say that he received a special bonus of Rs 2,00,000 in his job. How does he invest it? How much should he put in each pool? These decisions are difficult for a common investor. A single savings pool makes the task much simpler.
Excerpted with permission from The Little Book of Big Gains, Sandeep Tyagi, Bloomsbury India.
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