Investing Fundamentals

How to set financial goals and achieve them

It cannot be put into words how relevant this quote is to achieving your financial goals especially using mutual funds. This is exactly what we are going to talk about here.

The process of achieving a financial goal is pretty straightforward which is probably the best thing about it. However, let’s quickly visit the important steps and their finer details.

Identify Your Financial Goals

financial goals

This is the starting point which makes it probably the most important step of this entire exercise. It is extremely important to be able to identify and define financial goals. Some of the necessary attributes of any financial goal are –

Purpose of the financial goal

What are you looking to achieve? A house, a car, a vacation, your child’s education? Or simply saving for a rainy day?

Know the precise purpose of the financial goal. As far as possible, do not spend the penny you had saved for financial goal 1 on financial goal 2.

How much?

This is very important. When people come to us and tell us they want to save money for their child’s foreign education, they are mostly clueless about how much money they need to achieve the financial goal.

It is important that you do a thorough research or talk to a financial advisor to come to the appropriate amount you need to achieve the financial goal today as well as in the future! Don’t forget to consider inflation.

Timeline

Another important attribute your financial goal needs to have – a timeline.

How far is the financial goal in terms of time? This will help determine what instrument to use to achieve the financial goal.

It is important to mention that if you are doing this for the very first time, it is always good to seek help from a financial advisor.

It is also important that you do not become greedy or fearful while defining your goal. If your wallet size (present and future) allows you to own a hatchback, don’t shoot for a sedan. If you do, you probably will have to invest in riskier assets. This could harm even hurt your hatchback chances.

Create A Financial Goal Roadmap

financial goal

Once a financial goal has been identified and defined, the next logical step is to come up with a strategic plan that maximizes the possibility of achieving the financial goal.

This is probably the trickiest part of this entire process.

Let’s say you have a well-defined financial goal as the following –

“I have an 8-year-old daughter today. I want to create a corpus of Rs. 10,00,000 in today’s value for her graduation 10 years later.”

Well, great that you have identified and defined the financial goal so well. But how to reach there?

We wish this was as easy as saving Rs. 1,00,000 per year but it is not! You have to consider inflation, what instruments to use to reach the financial goal, how flexible is the financial goal in terms of time and corpus required etc.

For starters, if you consider inflation of 5%, the above goal gets converted to creating a corpus of about Rs. 16.3 Lakhs in 10 years’ time. Now you realize why saving Rs. 1,00,000 per year for 10 years will not take care of this goal.

However, if you smartly invest this money into various assets and instruments, you will be able to reach Rs. 16.3 Lakhs by saving and investing the same Rs. 1,00,000 per year or even lesser!

Next comes understanding diversification.

financial goals

The most popular wealth preservation (also wealth creation for some!) assets for retail level investors are fixed deposits and real estate/rental income. Indians born in the 60’s, 70’s and to some extent even in the 80’s swear by FD’s and rental income.

However, there are many more investment instruments which help you diversify your investments. Firstly, let us understand why diversification is important.

Think about it, what if you simply parked Rs. 10,00,000 in an FD today expecting an 8% interest and the bank collapsed midway? There goes your financial goal out of the window!

What if you bought a real estate property worth Rs. 10,00,000 today and it actually depreciated in value when you wanted to cash it? Or worse, there was an earthquake and you lost it to the almighty’s wrath!

We pray these scenarios are never faced by anyone (though there are uncountable instances of these). However, there is no way that we can ensure the expected outcome which is where diversification comes in.

Most people believe that they are diversifying their assets/returns. But no! You are actually diversifying your risk. The risk of losing it all in the case of an asset turning against you.

For example – The required rate of return on your investment is 10%. Meaning, a 10% return would almost ensure that you achieve your financial goal. To keep things simple, we will not be talking about a particular financial goal here or even the timelines, just the required rate of return.

A good number of people would be tempted to choose an equity asset (direct equities/equity mutual funds) which would give a return of 15%. The extra 5% rate of return can tempt the best of us.

However, it could well happen that the time to cash in the equity instrument coincides with a year like 1992, 2000 or 2008! We know what happened in these years, don’t we? For people who have no clue – these were years when stock market indices fell by over 50% in very short periods!

So be careful! That expected 15% return is not a simple proposition. It’s complicated by the equity risk which is pretty high for most.

You should ideally aim for a mix of 3-4-5 investment instruments which would have a weighted average of 10% return.

Let’s say, equity’s expected rate of return is 15%. That of fixed deposits is 7%. That of debt mutual funds is 8%. That of real estate is 5%.

A smart person would equally invest in equity, FD’s, debt mutual funds and real estate to get a weighted average expected return of 10%.

0.25×15% + 0.25×7% + 0.25×8% + 0.25×5% = 10%

This is diversification of risk.

Another factor to keep in mind while selection of investment instruments is taxation.

financial goals

The 10% that we calculated is subject to taxation. The taxation rules for different investment instruments are different. And you should be fully aware of the taxation liability each investment instrument carries as a baggage.

Taxation is the most important factor that makes debt mutual funds preferable over fixed deposits! Let’s see how.

A fixed deposits’ interest is almost fully taxable as per your marginal tax rate. If your taxable income after all deductions is greater than Rs. 10 Lakhs, then your fixed deposit interest component will be taxed at 30%. What does this imply?

Let’s say you park Rs. 100 in an FD for 5 years. The rate of return offered by the bank is 8%. Does this mean that you take home Rs. 147 after five years? Absolutely not!

Rs. 47 – the interest you earned – is subject to 30% tax. So, out of Rs. 47 you pay Rs. 16 to the government. Your take home amount is just Rs. 131 meaning the take home rate of return is 5.6% in this case.

Let’s say you park Rs. 100 in a debt mutual fund (short term fund) for 5 years. The expected rate of return is 8% again. Does this mean that you take home Rs. 147 after years? No, again! But this case turns out better than the FD case.

Firstly, the taxation is just 20%. Secondly, you enjoy the benefit of indexation. Indexation factors in the inflation. Here’s how the taxation implication on the debt fund works out.

The entire Rs. 47 gains are not subject to taxation. After the process of indexation (not a straightforward calculation and hence not described), the total taxable gains come out to be Rs. 15. Rs. 32 was straight exempted from tax liability. This takes to the overall tax you pay to Rs. 3. You take home Rs. 144 with an effective rate of return of 7.5%.

(For those who know and are wondering, the CII’s of FY 2012-13 and FY 2016-17 was considered. They are 1125 and 852 respectively)

Against an effective rate of return of an FD of 5.5%, you earn an effective rate of return of 7.5% on debt mutual funds. However, the rate of return assumed for a debt mutual fund is expected and not guaranteed unlike FD’s. At the same time, the debt mutual fund’s rate of return is subject to minimal fluctuations under most situations.

Similarly, you will have tax implications on equities and real estate/rental income etc. The simple point we are trying to drive home is consider the post-tax rate of return of the investment instrument which is what actually matters.

financial goals

By now, I am pretty sure you would have realized that creating the road map for your financial goal is not at all straightforward. If you are doing this for the first time, it’s best to talk to a financial advisor who would help you draw this roadmap.

Stick To The Financial Goal Roadmap

If creating a financial goal roadmap is the trickiest part, sticking to the roadmap is the most difficult part.

A lot of investors (mostly the new ones) are simply unable to stick to the roadmap. The reasons are many. Let’s have a look at the most common ones –

Fear

You expected a rate of return from an asset as 10%, but after 6 months when you check out the performance of the asset it has appreciated only at 4%. This makes you feel that the roadmap plotted had an intrinsic fault and you switch to a different roadmap.

This is extremely typical of new/first-time equity/mutual fund investors. We have a new wave of mutual fund investors coming in who have lost some money (or made less than expected) over short term periods like 6 months or 12 months. They simply run away from mutual funds and return to FD’s and real estate to never come back.

Well, when you start a roadmap you need to understand the volatility of every investment instrument you are going to invest in. Once understood, you need to decide if the volatility is going to affect your night’s sleep. If yes, simply refrain from the investment instrument.

What good is money that hampers your sleep!

Greed

This is the opposite of fear. You become fearful when you earn less than the expected rate of return. Similarly, you become greedy when you see a rate of return greater then the expected rate of return. Well, who wouldn’t? We’re just humans!

However, you need to understand that this is how most people think. If you see an asset grow in value rapidly, so does everyone! Like you, they also start accumulating that asset. Congratulations! You have participated in the creation of an asset bubble.

Once people realize that the price rise in the asset is purely speculative (rising in value simply because of speculation), the bubble bursts and all hell breaks loose. The price of the asset simply crashes.

Did you know our race conjured up a tulip bulb bubble (AKA tulip mania) once?

Be as careful about greed as you are about fear. Make sure you give in to neither.

The less fearful and the less greedy you are in your financial goal journey, the more likely you are to achieve it! What does this mean?

Discipline is the key. When you are disciplined, you are immune to fear and greed.

financial goals

Scrutinize the goal as much as you want while the roadmap is being laid down – seek expert advice on the roadmap, study it as much as you can yourself and do a realistic expectation setting with yourself. Know which assets are risky and which are not. Do all of this before you start your financial goal journey and never after.

Also, while setting up the roadmap, decide a review frequency. If you have a 15-year financial goal, decide before hand how many times would you review and intervene if necessary. This could be different for different investment instruments too!

For example, you need not review FD’s and rental income since they can be taken for granted but do have mental reminders. However, debt mutual funds and equity assets should be reviewed ideally every 1 year and 3 years respectively. Decide whatever seems right to you/your financial advisor and swear to never review/scrutinize before a review is actually due and never to miss a review either.

Achieve The Financial Goal

Here are the steps to achieve a financial goal again –

  1. Identify and define your financial goal
  2. Create a roadmap which maximizes your achievement of the financial goal
  3. Stick to the financial goal roadmap

If you go about the above steps fairly well, achieving the goal is a high probability event.

Hope this was helpful to you. If you are looking for someone to guide you through the process of financial goal achievement (especially using mutual funds), we have a recommendation.

About the author

Anurag Bhalerao

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