A Step-By-Step Guide to Long Term Goal-Based Investing – Part I

Here is a step-by-step to guide, plus calculator, to begin and track long term goal based-investing. The calculator will perform the steps detailed below. These steps are applicable for all goals except retirement.

1. Identify the goal, its time-frame and find out as accurately as possible how much it will cost today (i.e. when you start investing).

• Ball-park estimates can be dreadfully wrong. If you are saving for your child’s education, seek out a parent whose child is studying a decent degree (UG +PG) in a decent college and get the entire fee detail.

2. Assume a reasonable inflation rate (not the historical average). The higher the safer.
3. Using 1 and 2, determine how much the goal would cost at the time of need.
4. Determine how much you can invest after taking into account: expenses, loans, investment towards retirement (always the no. 1 goal).
5.  Estimate how much this investment amount will increase (or decrease!) in future. If after a loan payout, you can invest more, take this into account.
6. You can now determine the average rate of return required. Average here refers to the weighted average of returns from equity and debt instruments. The equity and debt returns themselves represent the expected compounded annualized growth rate (CAGR: a geometric average)
7. Depending on the time frame decide the debt instrument. If your goals if 15 financial years or more away then PPF is a good tax-free investment. You could also choose a debt fund like an ‘income’ fund. Estimate the post-tax return (say approx. 8% for PPF and 6% for a debt fund).
8. Decide on appropriate equity exposure. This is how I would do it.
   • For goals 15 or more years away: 50-70%
   • For goals 10 or more: about 40-50%
   • For goals 7 years away 20-30%

This is not just based on my risk appetite. It is based on history.

9. From 6, 7 and 8 the returned from equity needed can be estimated.
   • Anything more than 12% irrespective of time period is risky. Unless you have a good understanding of the market such returns it is best not to assume such high returns.
   • 12% only for time periods well above 10 years.
   • Anything less than 10 years expect something like 9-10%
10. If the equity return is too small and if the inflation rate assumed is reasonable you can afford to decrease the monthly investment. If equity return is anything more than 12%, it is best to lower it, irrespective of duration and perhaps expertise. In this case the investment has to be increased as much as possible.
    • Initial monthly investment could be increased and/or
    • % by which investment will increase annually (from year 2) can be increased and/or
    • Additional investment a few years down the line can be considered.
11. If you have increased the monthly investment as much as you can and still find the equity returns still unreasonably high, then
    • Consider postponing the goal if possible
    • If postponement is not possible then the goal can only be met partially
12. If goal can only be partially met estimate, with a reasonable equity return, the corpus that can be obtained. The shortfall will have to be met with external funding.
13. Finally you are ready to start investing! Spend no more than a week’s time to get going. Anything more will impact compounding. If you are someone who cannot use commonsense unaided then do consider joining a tutorial (like the 100moneyactions by Jagoinvestor!)
14.  So you are on your way. Pat yourself on the back and ensure the investing process is automated if you are indiscipled (that is start a SIP).
15. You can afford to relax for about a year. At the end of each year the returns have to monitored, the portfolio rebalanced (if necessary) and most crucially steps 1-12 have to be repeated (including the pat on the back!).
    • What is rebalancing? Why do it? What are the different ways of doing it? Which is preferred when? This is a post in itself (much more). Will write about this in part 2.
    • Assume reasonable rates of return for equity and debt. The sooner you start the lower your return expectation from equity. The more you can invest the lower your return expectation from equity.
    • Statutory warning: Garbage in, garbage out!

Download the Step-by-Step Goal-Based Investing Calculator

• Macros need to be enabled. Macro used is derived from Excel Workbook
• A standard goal calculator is also included for comparison.

Comprehensive Recurring Deposit Calculator

A recurring deposit (RD) is a terrific instrument for meeting important short-term goals. If I can claim to have some financial discipline it is because I observed my parents open RDs for meeting their short term goals ranging from paying insurance premium to my school fee. For the new generation of investors I guess the RD could be introduced  as a SIP in a debt fund with a predetermined rate of return!

For important short-term goals (say, 3 years or less) a RD is a guaranteed way of saving, irrespective of ones tax bracket. It is surprising to see many ‘experts’ talk only about debt funds and ignore RDs. If I wanted to save for my sons school-joining fee I will trust only a RD. If I wanted a SLR camera, and can wait an year or more, I will probably invest in a liquid debt fund or an ‘arbitage’ mutual fund.

The only issue with RDs is tax computation. Although banks do not deduct tax on RD interest it is entirely taxable and should be paid on accural basis,. That is interest earned in each financial year should be declared for tax computation. Taxation is as per income slab. Trouble is RDs are typically compounded quarterly and the interest earned each FY is not obvious at all.

Here is a RD calculator which give you the tax liability each FY for different types of compounding (annual, half-yearly, quarterly and monthly). This allows the user to change the monthly deposit until the post-tax corpus matches with the target.

Download the Comprehensive Recurring Deposit Calculator

This first appeared as a guest post in OneMint.

Here is a collection of good RD resources

Excel-based Mutual Fund Portfolio Tracker (Version 1)

Use this excel file to track returns from your SIP and lump sum mutual fund holdings. I have had several requests for making something like this. Didn’t do much about it until Mr. Vijay Hegde sent me his tracker file for inputs. I got inspired by it and decided to build one from the ground up with no resemblance to existing trackers.

Features/How to Use (File contains step-by-step instructions)

• Like all excel trackers this also can source daily NAV information from the AMFI website. I would like to think the resemblance ends there.
• I have focused on ‘average return’ or technically known as ‘Compounded Annual Growth Rate’ (CAGR) of the holdings. The idea is to ‘input’ minimum information and explicitly discourage users from updating NAV everyday!
• Each MF holding can be (or has to be!) entered in a separate worksheet. The file has a total of 10 such sheets: 3 of one kind (Pure SIP) and 7 of another (Mixed).
• Pure SIP: If you have a SIP in a growth MF with no redemption and lump sum transaction history and would like to keep it that in future then lets call it a Pure SIP. The tracker file can handle 3 such SIPs (you can make more yourself or I can help you do it). The advantage of such a Pure SIP is that transactions that occurred in the past need not be entered. You would need to know the value of your holding on some day and the corresponding NAV value. All future transactions (NAV value) will have to be logged. You can do it once a month using a SMS alert from the AMC or distributor or once in a few months using the account statement.
• A more intelligent way of using a Pure SIP sheet is not to enter any SIP transactions! Every few months one could enter the current value and get the CAGR. The CAGR calculation assumes SIP transactions are separated by 30 days. This separation depends on randomly occurring non-business days and can range from 28-33 days. So while Excel’s XIRR tool is the correct one to use, Excels’ Rate gives a very close answer.
• Mixed: A Mixed MF holding is one in which all kind of transactions have occurred in the past and is likely to occur in future. That is a SIP combined with occasional lump sum investments, redemption’s dividends etc. The tracker file can handle 7 such investments. All transactions (past/future) have to be entered for getting the correct CAGR. There is an option not to enter past returns but it will not yield the correct CAGR.
• You can use the file in many ways. For example if you have a SIP in a growth MF and make occasional lump sum investments you choose to either enter all the transactions in a Mixed sheet or enter SIP details in a Pure SIP sheet and lump sum investments in a Mixed sheet.
• Thus the focus is on computing CAGR and minimizing data entry and (advice against) constant monitoring. So it is an offline tracker with occasional online data query.
• A summary sheet with gives the % equity and debt holdings and the average weighted CAGR return is also provided. The holdings break up can be used to check if rebalancing is necessary or not.

Why Version 1? Hopefully future versions will include a number of features (some suggested by Vijay Hegde) like

• auto-obtain historical NAV for a particular date
• auto-obtain SIP value
• comparison with benchmarks (suggested by Vijay) to assess fund performance.
• FIFO logic for units (suggested by Vijay) redeemed for capital gain calculations
• Anything else that you can think of.

Download the Mutual Fund Excel Tracker

Statutory Warning: Refreshing NAV everyday and staring at MF holdings can be injurious to your fiscal health 

I would be delighted to hear your feedback. Suggestions for improvement are welcome.

Mutual Fund SIP Returns Calculator

Use this suite of calculators to compute SIP and lump sum returns, compute SIP corpus and determine SIP amount needed for a goal. This represents an upgrade of my understanding of (a) excel functions and (b) the compounding process. The calculators also help illustrate a common error in converting monthly  returns to annual returns.

First some yada yada  (to borrow a phrase from Google toolbar) if you don’t mind. Every since the blog got reasonably popular (for my standards) kind readers have called me an ‘Excel expert’ much to my embarrassment. Nothing is farther from the truth. The truth is  I use Excel because it is the only platform accessible to everyone. These calculators can be written in many platforms routinely used for physics research with much better efficiency. Truth is I am still unfamiliar with many Excel functions. I manage because, thanks to my training, I have realized that all of investment and amortization math stems from a single master equation. All one needs is high school algebra to manipulate the master equation to different situations. The Excel functions like FV, PV, IPMT etc. do just this.

Unfamiliarity with Excel features has certain disadvantages: Until yesterday I didn’t know that computing SIP returns can be done in a single step using an Excel function called RATE! I had earlier made a SIP returns calculator in a roundabout way resulting in a 5 Mb file with a minor bug (now corrected)!

The only saving grace is this version (post bug-fix) always returns the correct annual return. Most SIP returns and SIP goal calculators suffer from one flaw: If the assumed annual return is 12% they assume the monthly return is 12%/12 = 1%. This is incorrect. The correct monthly return is = (1+12%)¹² -1 = 0.949%. You may think this is a small difference. However when computing SIP corpus for a long tenure and when computing annual SIP returns (long and short tenures) it can make quite a big difference.

That said the correct return can easily be computed from the result of the RATE function. The roundabout method I have used maybe might be of some interest/use to enthusiasts, developers and planners.

So I present two versions of the SIP returns calculator:

Download the SIP-returns-investor-version

Contents: versatile SIP corpus calculator, goal planner, SIP and lump sum returns (CAGR) calculator

Download the SIP-returns-pro-version

Contents: investor version + my SIP CAGR calculator which directly returns the correct annual return

Updated: Pay off Home Loan or Invest For Retirement Calculator

Last week I had posted a calculator to figure out which is better:

(a). Pay off your home loan asap and then step up retirement investment

or

(b). Let the home loan  run its natural course and invest as much as possible for retirement.

I now post a revised version of this calculator with the following features:

1. Subra(money.com) mentioned an interesting possibility: If the outstanding loan balance falls below a certain amount then a lower interest rate may be applicable. A lump sum payment to the lender can make this possible.

For example (assuming my understanding is correct):  Let us assume that the rate applicable for amounts above Rs. 30 lakhs is 11% and 10.5% below. Suppose my loan balance is Rs. 34 lakhs and I  pay a lump sum of Rs. 5 lakhs (if possible!) to the lender. The the balance drops to 29 lakhs. I then ask the lender to lower the rate to 10.5%. If I keep the EMI amount the same then the principal component increases considerably. The loan tenure will then decrease.

This possibility has been incorporated in the calculator.

2. Ms. Tinkerbells who has provided valuable feedback on several calculators pointed out a confusing aspect of the lump sum payment in the earlier version. This also has been corrected.

What should one do? Pay off home loan or invest for retirement?

If you wish to retire by 40-45 (implying you are likely to spend a good 40 years in retirement!)  then and only then it makes sense to close out your home loan asap and then invest for retirement.

If you intend to retire by 60 (20-25 years in retirement) then to ensure financial independence during retirement you will need to invest as soon as possible and as much as possible and let the home loan run its natural course.

People talk about ‘emotional’, ‘psychological’  and ‘parental’ (as Subra points out) pressures to close the home loan asap. If  you give in to such forces it is quite possible that you may not be financially independent during retirement.

Download the updated Pay off loan or invest calculator

The Games Life Insurers play!

“Applying for term insurance? Be sure to be honest when you apply and disclose all relevant facts. Your (nominees) claim cannot be rejected” Does this advice sound familiar? I have offered it to others myself. The question is, is this advice correct?

The answer is ‘Yes’ but … there is no guarantee that the claim settlement will be prompt. There is no guarantee that the ombudsman will not be involved.

Some people think a medical test conducted prior to issuing a policy is the best way to ensure claims will not be rejected.  Medical tests have nothing to do with prompt claim settlement! In this case too there is no guarantee that the claim settlement will be prompt. No guarantee that the ombudsman will not be involved.

Here are a collection of bizarre claim settlement stories catalogued by the Insurance Ombudsman. These stories are from book 7.

1. SBI Life rejects claim based on evidence from a Apollo hospitals doctor that deceased had medical conditions prior to issue of policy which were concealed at the time of application. Wife shows documentary evidence of onset of medical condition more than two years after policy inception. Deceased was never treated at Apollo hospitals!! Ombudsman directs claim be honored invoking section 45 of life insurance act (see below). It was a housing loan policy worth Rs. 6 lakhs. Since it was a decreasing cover the policy amt at the time of death would have been much less than Rs. 6 lakhs!

2.  ‘Aviva Life’ rejects claim based on minor sons statement that his father was treated for ‘some’ disease for last 5 years (prior to policy inception)!! Ombudsman invokes section 45. Aviva told to pay up.

3. SBI LIfe rejects claims stating insurer suffered from pulmonary fibrosis prior to inception of policy without proof. Told to pay! No evidence of such illness on date of medical test or date of declaration of good health (or DGH see below)

4.Mother says son died of chest pain. Mother-in-law says it is suicide! LIC rejects claim based on mother-in-laws statement with no other proof! Told to pay.

5. A person manufacturing illicit alcohol is assumed to be a chronic alcoholic. ‘Max New York Life’ rejects claim that alcoholism was suppressed while applying for policy without proof. Ombudsman directs claim be honored invoking section 45 of life insurance act.  Not relevant to everyone you think ? Perhaps only bartenders should beware?! Those who work on-site too (why?).

Facts:

• Who do you think got statements from the minor son, the irate mother-in-law? Insurers often employ private detectives to investigate claims.
• Everyone the deceased ever made contact with is a potential source of damning information for the insurer. This could include your present and former wives/GFs. Present and former colleagues and neighbours. The guy who handles your leave (taken too much ‘sick’ leave?). The pharmacy guy from where you get your medicines.
• Most of the examples in the ombudsman catalogues involves policies worth only a few lakh. Typical term insurance policies are worth tens of lakhs! Therefore … care to complete?

What’s the point?

Term insurance is taken for only one purpose: for the financial security of our family when we die. When we take the policy we assume that this financial security will reach the family asap. This is by no means a certainty. It depends on when we die and how we die. Even for ‘simple’ deaths of individuals with policies more than 2 years old there can be inordinate delays. Yes, yes if the deceased had been honest while applying (which is mere common sense) then there is no chance the claim will be rejected … by the ombudsman. There is no guarantee of early claim settlement.

The point is having enough life insurance and honestly applying for it is necessary for eventual claim settlement but not sufficient for hassle-free claim settlement.

Am I being paranoid? I call it pessimism. For a given situation I would like to understand all possible influential factors so that I can prepare myself and in this case prepare my nominee and family for the same. They may not take it seriously now but if I print this post and attach it to my policy document the message will get across when needed.

What more can be done?

• Pray that we live for at least two years after the policy is issued! (read Section 45 and its corollary!)
• Live a good dignified life. Treat everyone around us with kindness. There is a financial reason to do so!

DGH: The Declaration of Good Health requires no ‘physical deformity, mental disorder, critical illness or any condition require medical treatment for ‘critical illness’ as on the date of DGH’

Section 45 of Insurance Act 1938 – Indisputability Clause
No policy of Life Insurance shall, after the expiry of two years from the date on which it was effected, be called in question by an Insurer on the ground that a statement made in the proposal for insurance or any report of a medical officer or referee or friend of the Insured or in any other document leading to the issue of the Policy, was inaccurate or false, unless the insurer shows such statement was on material* matter or suppressed facts which it was material to disclose and that it was fraudulently made by the policy holder and that the policy holder knew at the time of making it that the statement was false or that it suppressed facts which it was material to disclose.

* “Material” shall mean and include all important, essential and relevant information in the context of underwriting the risk to be covered by the corporation.

Corollary:  I am not a legal expert but to me section 45 implies, ‘if the policy is not two years old the insurer can dispute claim without proof’. Of course the ombudsman will offer judgment in favour of the nominee … eventually.

Calculator to Compare Lump Sum Investment Returns

The following appeared as a guest post in BasuNivesh Learn…Invest…Succeed !!! on May 1st 2013. The blog is authored by Basavaraj Tonagatti a Certified Financial Planner from Bangalore. His posts are honest, sincere and balanced.

All of us would like to get better returns on our investments. However with returns or capital gain comes knocking its evil twin – taxes. American entertainer Will Rogers once said, “The only difference between death and taxes is that death doesn’t get worse …”!

Trouble is tax rules are different for different investments. If a holding period of 1 year is considered ‘long term’ for capital gain taxation of Gold ETFs, it is 3 years for E-gold. To add to that the taxation rules also differ. This makes it difficult to compare the two and decide which is better if I want to invest for just a few years or many years.

Consider fixed deposits and debt funds. Both are ‘debt’ products. However tax on FD (or RD) interest should be declared and paid on accrual basis (that is each year) while tax on debt funds can be deferred until redemption. This can make a considerable difference in the corpus if the investment period is long.

The main problem is most investment calculators available online do not take into account taxation rules. Based on the suggestions of Basavaraj and a few encouraging readers like Kapil Tiwari, I have made a calculator with gives the post-tax corpus of several common instruments for a given lump sum investment. It also includes a table in which the tax rules for different instruments are listed to serve as a ready-reckoner. The minimum investment period considered is 1 year. So only long term capital gains will be computed.

A recurring deposit calculator with a table listing the monthly pre-tax and post-tax interest earned is also available (I will post an updated version of this separately).

Use the calculators and let us know your feedback. Suggestions to modify the calculator are welcome.

Download the Lump Sum Investment Returns Comparator

Download the Recurring Deposit Calculator