I have written earlier on retirement planning here and here. There were several comments on both the posts and so I have decided to start this post with a Q&A

Q1: I think gold/ commodity (put any asset you like) is good and I do not agree with your point that one should avoid it

My response: If you know what you are doing and have the knowledge and the skill to invest, then please go for it. My specific point is that if you are a know nothing or a newbie in these asset classes, then play around a bit with small amounts of money till you get a hang of it. The market will not forgive you for your ignorance.

Q2: Are the asset allocation percentages fixed. Should one not vary them based on market condition?

My response: Asset allocations are not set in stone. However one should remember that asset allocation will play a big role in determining the return on your portfolio. So one should fix the asset allocation based on one’s risk tolerance. Translation of this mumbo jumbo – In my own case, I will only invest as much in equity in which I can tolerate a 50% temporary drop. As a matter of fact, the market dropped by almost 50% last year and most of us got a taste of how much drop we could tolerate without losing sleep.

Q3: There is no mention of insurance, ULIP and other hybrid schemes

My response: Pure risk insurance is important and one should always have an adequate insurance cover (more on that in another post). However I completely and totally hate ULIP and such unit linked plans. They are a complete rip off and one should stay away from them.

In my own case, I said no to a close relative who was pushing this kind of scheme. I told him that I will give you the incentive you get from the company for free as long as I don’t have to buy the scheme from you (that way he benefits and I don’t lose money for the next 20 years). You can guess how happy he is with me J .

Please do not invest in such schemes unless you have analyzed them in detail. It is far better to buy the insurance and the fixed income/ equity piece separately than bundling it via unit link schemes, pay the high commissions and expense loads and lock the money for a long period of time.

Asset allocation and rebalancing
I have written about how asset allocation drives you portfolio returns. All of us think we can tolerate risk and can afford to have a high equity component. My suggestion is to keep it lower than the level you think you can maintain without losing sleep.

Let’s say you are looking at 11-13% returns and are planning to keep around 50-55% of your portfolio in equity. I would suggest that one should start with a 30-35% allocation and go through a bear market and see how one is able to survive it. If you are able to avoid the gloom and doom and still able to invest during the bear, then go ahead and start raising the allocation. It is easy to maintain a high equity allocation during a bull market. We are all geniuses during bull runs. The test of patience and risk tolerance is during a bear market.

Finally if one is not actively managing his or her investment, then it makes sense to start reducing the equity holdings during a bull run to bring it to the target allocation. For example, if you target is 40% and the equity components goes up during the bull market to 60% of your portfolio, then it makes sense to start liquidating some equities to bring it to around 40%. In contrast, if your allocation drops to 30% during the bear market, then one should start buying equity to bring it up to the target level.

The above suggestion is easy to understand and very difficult to execute. I have personally gone through this last year. It felt like quick sand. I was constantly adding money from March 2008 to my equity portfolio and the market kept dropping at the same time. So at the end of the year, the absolute value of the equity portfolio stood at the same level as the start of the year, inspite of pouring money into it. It is not easy to constantly lose money in face of a bear market.

One can further split the allocation between different instruments in each of the categories. One can split the debt component into Bank FDs, Debt funds, Post office deposits etc. In a similar manner the equity component can be split between mutual funds and shares. The actual numbers need not be precise and you do not have to get very scientific on it. As long as you are close to your target levels, it should work out fine.

Administrative effort
This is an ignored, but important component of portfolio planning. It does not make sense to invest in an option where there is a lot of documentation and other risks and costs involved. In the past, shares could be bought and sold only in the physical format and there was always a risk of bogus shares and the headache of paperwork.

In a similar manner mutual fund investing also involved a decent amount of paperwork. Luckily most investment options (except Post office schemes and Bank FDs like that of SBI) are now convenient and easy to manage. However one should keep in mind the paperwork involved in the specific investment option. My own preference is to look for option which requires minimal paperwork, allows online mode of investing – preferably automated, and does not require me to track payments and receipts on an ongoing basis. I also prefer investment options which would allow me to pull an electronic statement at the end of the year for tax purposes.

Most of the investment options and firm providing them are focused on making it smoother and easier for the investor. However we still have some options such as the post office and public sector banks which believe in torturing you, even when they take your money.

Scratched the surface
The entire topic of retirement planning which is a subset of personal finance is a vast topic. One could write a book on it and could easily update it on an annual basis. I have tried to scratch the surface here and just provide some initial thoughts or factors to look at when developing your portfolio for your or your parent’s retirement.

If you have to take one point from my posts, it should be this – Invest with full knowledge and understanding of the investment option and always focus on the risk or downside.

Please feel free to leave me any questions on the above topic in the comments section and I will be glad to answer them.

I do not plan to layout a template which can be followed step by step to plan for retirement. It would be difficult to do that as individual circumstances vary and so would the solution. My attempt in this post and the next would be to layout my thought process on various factors for retirement planning which can be used to think through and execute a plan.

Risk and return
The starting of risk and return should be risk and not returns. One should not start with a return target of x% and then work out the investment plan. On the contrary, it is important to look at your risk tolerance and how much time you would have to cover losses, if any.

Risk tolerance in turn is a difficult and subjective topic. What is risky for me, may be low risk for you. As a result, risk should be analyzed from a personal perspective. I personally do not follow the typical risk measures of beta and other such academic concepts.

I look at risk as doing something without the knowledge and experience to do it, especially where I do not have a clear view on how much I can lose in the worst case scenario. Lets explore that point further – Lets say I wish to invest for my family in such a way that they are able to get a return of 10-12% over 3-5 year period. It is easy to get around 8% through FDs and other such fixed income instruments. In order to get the extra 2-3% per annum, I need to look at equity to improve the returns.

My own personal experience and the last 10-25 yr data shows that the BSE index has returned between 12-15% per annum over the long term. However at the same time, this average return has been marked by 30% drops and 40% increases too. So in this case I can look at index funds as a possible option as I have a rough idea of the risk and return profile.

Now suppose someone suggests that I should invest in gold or real estate as these are good hedges against inflation. I would hesitate for multiple reasons

– I have never invested personally in these asset classes for investment purpose.
– There is lack of enough long term information and transparency in case of real estate (or atleast I do not have access to it)
– Gold has not provided good long term returns over the last 20 yrs. Now the next 10 yrs could be different and there seem to be a lot of pundits saying so, but I don’t have the data to validate it and hence would stay away from it.

In a nutshell, risk for me is a lack of understanding the investment option in terms of the long term return and the maximum possible loss under various scenarios.

Expected returns
The next aspect of investment planning is returns. Returns are closely tied with the level of knowledge and sophistication one can bring to the process of investing. Let’s look at some scenarios

The know nothing investor – you have no idea of investing and have never invested in the stock market. Your idea of a bull market is the bull or cow you may have seen in a local indian market J. A person who has no idea of even the basics of investing should look at investing in bank FDs and look at 7-8% returns. Such an individual when planning for retirement for self or for parents should not go beyond these FDs. There is however a risk for such an investor too. The risk is inflation. As the investor is barely earning 1-2 % above inflation (or even less), there is serious risk that the investor would not be able to support himself with the excess 1-2% returns over inflation. If the investor draws any more than 3% of the capital per annum for expenses, he or she will run out of money in due course of time

The beginner – you have some idea of investing. You have invested a little bit in mutual funds. You typically watch CNBC and think the anchors are dispensing good advise. Your idea of the stock market is that this place is like a casino where you can make it big or lose money big time. A person at this stage is at the highest risk of losing his or her capital. Half knowledge is always dangerous. A person at this stage needs to decide whether he is ready to invest the time to learn more about investing. If this person is not ready to invest the time and energy to do so, then the best option for such a person is to invest a small portion of his capital every month in a good index fund (via a systematic investment plan) and the rest in bank FDs. If the person is able to keep a 40-60 asset allocation (40% in equities), he or she can expect 10-11% returns over the long term.

The key issue for such an investor is that he or she needs to start saving and investing early in life and reduce the equity allocation to a max of 20% after retirement. I would not recommend an equity exposure (via index funds) of more than 20% of capital for anyone in this group who has crossed retirement.

The sophisticated investor – This kind of investor has been investing for the last 6-7 years. He or she has seen 1-2 bear market and has not been scared by it. He understands the risk involved in investing and has a fair amount of risk management skills. If you parents fall in this bucket, I doubt they would need your help.

If you are planning your own retirement and have 15-20 years to go, then you are in a good position. A 60-70% allocation in equities can be maintained. A 30-40% investment in stocks with the rest in good mutuals or index funds can be built via a systematic investment plan (investing a fixed amount of money each month).

This kind of investor needs to keep the long term in mind and should avoid a short term approach of performance chasing. The risk of losing capital for an extra 2-3% is fairly high and should be avoided. An investor in this group can expect around 13-15% return in the long run and if he or she starts an investment program early, should be able to retire very comfortably

The expert or the guru – This kind of investor has been investing for more than a decade. He or she has beaten the pants out of the market (in excess of 20%). If you parents are in this group, congratulations !!. They will take care of your retirement 🙂

If you fall in this group, I am not sure why you are reading this post. A person in this group has no reason to think or worry about his or her retirement. Any one who can compound money in excess of 20% can retire a very rich man ( for ex: such a person can convert 100000 to 40 lacs in 20 years). A person in this category can manage money for others and become seriously rich before his or her retirement.

Various instruments
In the above discussion I have discussed about fixed income instruments and equities. You would have noticed a lack of discussion about other assets such as real estate, gold, commodities, options etc. Let me share some thoughts on the various asset classes below

fixed income : One can expect returns in the range of 6-8% and low risk. Typical options are bank FDs, Post office deposits and debt mutual funds. All these options are low to very moderate risk and good for the first two group of investors (the know nothing and the beginner)

Equities : One can expect returns in the range of 12-14 %. Typical options are index funds and mutual funds. This option has moderate to high risk and should be handled with care. A beginner should look at only index funds or some good mutual funds. A sophisticated investor can look at stocks as long as he or she knows what they are doing. A lot of investors and financial planners would like to assume that equities can returns in excess of 20%. However the indian markets over the last 15-20 yrs (a typical retirement planning horizon) have returned around 13-14% and I would not like to assume anything more than that when planning for retirement.

Real estate : This asset class has become a hot favorite in the last few years. However the long term history of real estate across the world and across time horizons is that the returns from this asset class are 1-2% lower than equity. If you are beginner or a know nothing investor, I would really not look at putting money in real estate (other than for primary residence). This is an illiquid asset class with lack of transparency in india. If you are a sophisticated investor, then it may be possible to get a fair return, but then one has to be ready to spend the required time managing it too. I have written about real estate here in the past

Gold, commodities, and options – I have clubbed all these options on purpose. If you are a know nothing or beginner, I would stay away from these assets as far as possible. In these categories I will buy gold when I am buying jewelry for my wife and commodities when I need sugar or wheat for my kitchen :). The only group which should invest in these assets should be the experts. I would even say that sophisticated investors should not look at these assets for long term investing. If you need an ego boost, invest a little bit for fun, but If you are not an expert, you can get you’re a** kicked big time in the market.

If the above post has not put you to sleep already, then the next one will surely do it 🙂 I plan to cover the following topics – asset allocation, admin tasks, portfolio rebalancing and finally putting it all together