We all need money to take care of our current and future requirements. At times the propellant is our sole desire to earn/grow a lot of money losing focus on what for do we need it at the first place. This causes us to risk the money which we probably required for some non-negotiable urgent requirements. If the expectations of higher returns do not fructify in the desired time-frame, it might lead to a stressful financial situation. The confusion arises due to part awareness of various available options, and lack of clarity on the wholistic philosophy. We are driven by peer pressures/advice, enabled by easy availability of options, and swayed by aggressive marketing of financial products.
We have seen in our earlier discussions the correlation between Risk & Return, and the importance of diversification. While it is clear that higher returns can accrue only by escalating the risk, we should also understand that money required for immediate needs cannot be risked. A common factor associated with Risk & Return is Time. In financial instruments like Equity which bear higher risks, the assurance of higher returns increases with duration. This implies that one needs to have patience. Giving more time to the option means that it would not be advantageous to withdraw it soon. This money is therefore not available for short term needs. The natural corollary is that we should not invest the money needed for short/medium term needs in risky investment options like Equity.
What is Short and Medium Term ?
Short term could be anything from two months to a year depending on the source of income of an individual. Salaried persons have a reasonably assured and predictable cash inflow, and their short term can be shorter than those with unpredictable cash flows. The money required in short term is what we need for basic sustenance and functional expenses. It will also include money needed for any planned expenditure during that period. The medium term can be from one to five years. The money required here is for any expenses that we have planned/anticipated during this period. We have discussed earlier about the need and method of formulating financial objectives with time frames in the article“ Want to Create Wealth- But How Much- And by When”.
Money for Short and Medium Term
We should keep the funds needed in the short term at the safest place with easy liquidity. The options available to us are to keep it as cash, or in savings/fixed deposits. Liquid funds are also a good option to keep contingency funds in the short term. Any instrument which gives an acceptable assured return with easy liquidity can be used for the purpose. The money needed for Medium term should be kept in debt instruments like Provident Funds, PPF or Debt Mutual Funds which have some lock in period, but give better tax efficient returns with adequate safety. We can redeem/ roll over the funds as and when the short/medium terms shift.
Where Should the Balance Money Go ?
After catering for the money required in the short & medium term, we can deploy the balance funds in growth options which can yield higher returns, albeit at a risk. However, we have also discussed earlier that the asset diversification involves putting a reasonable proportion of funds in safe avenues only. A general guideline is to put the percentage equivalent to your age in debt options. For eg 40 years old should have at least 40% of his funds in debt options only. This means that even if the short- and medium-term needs are catered for by funds less than the desired proportion of debt allocation, the balance of debt allocation should also be deployed in debt instruments only. The funds over and above the decided debt portion can be used to invest in growth avenues like Equity, Real Estate or others.
Example
Let us try to understand this with the help of an eg.
Mr X, who is 55 yrs of age, has a fund of ₹ 75 lakhs. He envisages an expenditure of about ₹ 5 lakh over and above his monthly income in the coming one year. Mr X also needs another 15 lakhs for some objectives which fall in next five years. He intends keeping the balance of the money for retirement and other objectives beyond five years. Mr X is also a moderately conservative investor and intends to limit exposure to equity to the guiding formula of (100- Age) ie 45%.
Mr X should put 5 lakhs in either savings account, or some short-term FD, or a Liquid Fund. He can put the ₹ 15 lakhs needed in next five years in FDs, Tax Saving schemes, or short- and medium-term Debt Funds. This makes a total of ₹ 20 lakh which is about 26% of his Funds. The Debt portion for Mr X is 55% which amounts to approximately ₹ 41 lakhs. He can therefore invest the additional ₹ 21 lakhs in Long Term Debt Funds. He can consider investing the balance of ₹ 34 Lakhs in Equity Instruments.
Recommendations
The above example is just a rough guideline, and can be suitably modified in individual context. The Key takeaway points are:-
(a) Don’t risk the money which you might require for short- and medium-term needs.
(b) Risk bearing instruments generally need time to give expected returns.
(c) Review your fund allocation at least once every year to readjust overall proportion between Debt and Equity.
(d) Judiciously employ funds needed in the long term to generate higher returns by investing in Equity.
(e) Keep your own Risk-taking capability and Risk Appetite in mind while allocating funds between Debt and Equity.