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Goals and Risk Profiles II

Last week, we explored what a risk profile means, its implications on your asset allocation and also debunked a myth that your risk profile is linked with your age. Here’s a quick recap of it. Alternatively, read through the entire article here.

  • Key factors determining your risk profile are
  1. Your future financial goals
  2. Your Emotional Quotient
  3. Time spent by you analyzing and researching investments
  • Debt Investments – lower risk, potentially lower (but stable) returns
  • Equity Investments – higher risk, potentially higher (but unstable) returns
  • Your risk profile (amongst other factors) determines your asset allocation

If you resonate with the above, then congratulations! You are out of the Matrix.

I can estimate my risk profile now but what are financial goals?

A financial goal is a destination. Investing is a journey to that destination.

We all learn the concept of saving since childhood. Remember your piggy bank where you saved up to buy an action figure toy? That’s a financial goal.

But let us define it in more detail. A financial goal should have

  1. The “what” – A purpose – could be a vacation, education, marriage, your retirement (or financial independence as we call it), just about anything that money can buy you
  1. The “when” – A time horizon – you wont wait indefinitely for that vacation, would you? You have to visit Disneyland before your kids outgrow it. Some goals like a vacation have flexible timelines – missing them by a few months wouldn’t matter. But some goals like paying for your/your child’s education have hard timelines that are completely inflexible.
  1. The “how much” – An Amount – of course, you need to quantify your goal

Why should I define financial goals?

Defining financial goals helps you allocate investments with the specific purpose of meeting those plans. A financial goal is the answer to the questions “Where do I invest?” and “How much do I invest?”. This table should give you the gist.

GoalTimelineAmountDebt Allocation *Equity Allocation *
Europe Tour2 years from now5,00,000MoreVery low to nil
Car6 months from now10,00,000MoreNil
Buying a house5 years from now1,00,00,000LessMore
Child’s education15 years25,00,000LessMore
Retirement (We don’t like this word, more on it later)35 yearsHow the hell do I estimate this? We have a blog coming up on this soon!LessMore

*How much “less” or “more” debt and equity allocation is determined by your risk profile.

Are you seeing a trend here? The shorter the timeline of the goal, the higher the allocation towards debt. This is because investments in equity can lead to erosion in principal over a short term. Over a longer term, equity provides higher return than debt.

How should I go about defining financial goals?

There are some goals in life that you will have to meet. Come what may. Plan for those goals first. The order of preference, in my opinion, should be as under:

  1. Retirement – Whatever you do, a day will come when you have to retire. Your current income stream from active work will stop. This is inevitable. Plan for it!

Side note: We do not like the word “retirement”. We believe in financial independence itself. Retirement is forced on you, retirement makes you less active. Financial independence is achieved by you, not imposed on you. It enables you to pursue whatever you wish.

  1. Child’s education – We all want the best for our children, don’t we? Again, educating your children is inevitable.
  1. House – Buying a house is a dream for all of us. But it’s not inevitable. You can always live in a rented house. Hence, the other 2 goals take priority over this.
  1. Child’s marriage – We all want to save for this. It may or may not be inevitable.

These 4 life events are important, and hence should be planned for. Once that is done, shorter term goals (which I call as consumption goals) such as vacations, buying a car etc can be planned for.

Do note here that I am nowhere implying that you achieve your long-term goals before investing for short term goals. However, it is wise to plan for long term goals before you plan for short term goals.

What do you mean by goal planning?

Goal planning is simply allocating a part of your active income into investments based on the allocation for each goal.

There are 4 mathematical variables involved here

  1. The timeline of the goal – this is more or less known
  2. The corpus required at the end of the timeline – this is more or less known
  3. The returns your investments will fetch – this is estimated
  4. The amount required to be invested every month to achieve the goal – this is calculated on the basis of 1, 2 and 3 above

Once you have planned for (i.e. allocated periodic investments for the 4 major life goals), feel free to plan for your short-term goals.

What happens if I plan too many short-term goals?

Too many short-term goals would mean large part of your money sitting in debt investments. And that in turn means lower returns, albeit lower risk.

However, the hazard in this is that you will achieve all your short-term goals at the risk of not achieving your long-term goals which are more crucial and inevitable.

Your money is finite and it deserves to be allocated efficiently.

I have myself given up short term goals multiple times in favour of long term goals and it has always worked out. Short term goals have to pass Raju’s filter below:

I have been wanting to buy an apple watch ever since it was launched. Apple is currently on Watch 6 and I still hadn’t got one. Every year, I invested the cost of an apple watch into my long-term financial independence goal. The return on that money is enough to buy an apple watch today without disturbing my corpus. Isn’t that what financial independence truly is? – wanting to do what you wish without worrying about money!

Had I planned a short-term goal of buying an apple watch in 2015, I would just have had an apple watch!

My top priority remains allocating most of my money towards my long-term goal of financial freedom. That is my core portfolio.

We should endeavour to not fall prey to this mindset of Bandya and Gundya, as far as short term consumption goals are concerned.

Because it always leads to this

In summary:

  • Your risk profile is determined by your financial goals, emotional quotient and time spent on researching investments rather than your age.
  • An aggressive risk profile implies higher allocation to equity investments; a conservative risk profile implies higher allocation to debt investments.
  • Define financial goals, it helps in planning your investments better.
  • Longer term financial goals imply higher allocation to equity investments; shorter term financial goals imply higher allocation to debt investments.
  • Plan for inevitable long-term goals. Retirement is a beast that’s tough to tackle!
  • Always favour long-term goals over short-term consumption goals.
  • Your goals and risk profile are an important (but not the only) factor determining your asset allocation.

Don’t ask someone “Is this stock good?”, “Can I buy this stock?”, “Should I sell this stock?”, “Will this stock go up?”, “Whats the target? Stop loss?”.

Instead, ask yourself, “Does this stock fit into my goals?”, if yes, then “what % of my portfolio should it be?”.

Here’s a tip – The next time you get that call giving you stock tips, learn from Babu Bhaiya on how to respond.

Ok, maybe you can exclude the expletives, but you get the point.

In the coming few weeks, we will cover more on the above questions and also on asset allocation which is point 2 of the 5 point investment plan from my earlier blog.

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