Setting financial goals: Where it all begins

Setting financial goals: Where it all begins

One of the basic questions that most investors are up against is, “How to start investing”? To begin with, you cannot invest in random. Buying a random stock or a mutual fund is not the answer. Your investments have to be directed towards a goal and that goal has to be a financial goal. That is the basis of financial planning. You first lay out your long term and medium term goals, then assign a monetary value to these goals and finally work out your investment mix to attain these goals without assuming too much risk. How do you set financial goals for yourself? Here is how the self-assessment has to be done.

For financial planning, the task is to clearly define goals in financial terms. Unless you know how much money is required it is hard to set target corpus and plan for it accordingly. Goals can be varied and include paying the margin money for your car, paying the margin money for your apartment, paying the upfront fee for your child’s schooling, creating an emergency corpus, etc. These goals are short term in nature. Then there are goal like planning for your retirement and for your child’s education or marriage which are very long term goals with a time frame of 15-25 years. This classification of long term and short goals lies at the base of goal setting. Let us understand this point in greater detail.

How do we stratify short term goals and long term goals?

As the very name suggests, short term goals are those which fructify in the next 3 to 5 years. We don’t plan to buy a car after 10 years or book an apartment after 15 years. These goals typically fructify within the next 3-5 years. While a car or home will be substantially funded by loans, there is a margin of 15-20% which you will be required to bring in. It may be tough to pay margin money out of your regular earnings and personal loans may be unnecessary high-cost debt. A better way would be to plan your margin payout well in advance and invest in a systematic investment plan (SIP) on a regular basis to reach the goal.

Goals with a time frame of 5-10 years are medium-term goals while goals that mature beyond 10 years are long term goals. Why is this classification so important? Your asset mix and your liquidity management strategy will largely depend on whether the goal is a short term goal or a long term goal. Your risk capacity will be much higher in case of long term goals as compared to short term goals and that will largely determine your asset mix. Normally, you peg short term funds to short term goals; balanced or debt funds to medium term goals and equity funds to long term goals.

How to go about setting short term and long term goals?

Before setting goals and planning investments, you need to first understand the process of setting short term and long term goals. Firstly, you begin by writing down your goals on a paper and sign off on it. Secondly, you assign a future value to these goals by extrapolating the present structure using inflation assumptions. Thirdly, you peg long term and short term investments to respective goals based on the returns assumption. Lastly, the portfolio once created has to be continuously monitored against the goals and the goalposts and rebalancing done whenever warranted. Here is why the stratification of long term goals and short term goals is so critical.

• Your risk appetite will change based on the classification of short term versus long term goals. For a goal maturing in 3 years, there is only limited risk that you can take. Equities can generate wealth in the long run but they are not guaranteed to generate returns within a time frame of 3 years. While you have a much lower risk appetite in case of short term goals, you can afford to absorb a bigger risk in case of long term goals.

 • The classification of short term versus long term above is the key to your investment mix. For instance, if a specified goal is maturing in 3 years then you cannot have an equity portfolio. It needs to be weighted in favour of debt. But,  if your goal (like retirement or child’s education) is maturing after 15 years, you have the luxury of a bigger allocation to equities. The nature of the goal determines your asset mix.

 • To understand the power of long term equity investing via the power of compounding, check the table below:

 

Particulars

3-year SIP

Particulars

15-year SIP

Monthly SIP

Rs.10,000

Monthly SIP

Rs.10,000

No. of Months

36 Months

No. of Months

180 Months

Annualized Yield

15%

Annualized Yield

15%

Total Investment

Rs.3,60,000

Total Investment

Rs.18,00,000

Cumulative Value

Rs.4,56,794

Cumulative Value

Rs.67,68,631

Cumulating Factor

1.27 times

Cumulating Factor

3.76 times

 

Power of compounding hardly makes an impact in 3 years but makes a substantial impact over 15 years. This makes it possible to create more wealth in the long run via equities due to the impact of compounding.

• Liquidity is a key consideration in your long term versus short term goals classification. In the case of short term goals, liquidity is not an issue since you are anyways invested in near-cash assets. Does liquidity matter in case of long term goals? For that, you need to understand the concept of liquidity shift. A liquidity shift refers to converting your risky positions into risk-free positions ahead of the milestone date. This avoids unnecessary surprises to your financial plan due to goal-time volatility. In the case of long term goals, the conversion to liquid assets closer to the actual milestone date has to happen gradually.

Demarcation of short term and long term goals lies at the core of financial planning and that is where your road to financial freedom begins.