Saturday, March 28, 2009

Asset Allocation

Financial planning

Subsequent to my last blog post, I had a couple of friends asking me as to what an ideal financial plan looked like. Well, there is no ideal financial plan! There are plans that talk of what’s best for a typical investor. But you are not a typical investor, you are you! So, at the best you could have a few thumb rules, but there is no substitute for working with your financial planner in developing a plan that works for you. In this blog, I discuss some of the thumb rules.

Taking stock

Before you start off on putting together the plan you need to know what your financial position is. You need to have a handle on your assets, liabilities, income and expenses. This is no rocket science. Just make a list of the things of value you own, things like your house, stocks and bonds, MF investments, bank deposits, PF balance, etc. Similarly list out all the loans you may have taken. Then look at your income, include salary income and regular income from all other sources. Finally, look at your expenses. Make a distinction between your discretionary and non-discretionary expenses. The former are expenses that you should be willing to forego to hasten your journey towards financial freedom. This could, for instance, mean cutting down on the number of restaurant visits, watching that latest movie at home rather than at the multiplex, etc. Please be easy on yourselves as you do this. Cutting out all the spend on recreation – for instance- may make the journey towards financial freedom appear as not being worth the trouble.

Asset allocation

Now that you know where you stand financially, you need to set your financial goals and allocate investments to achieve those goals. Asset allocation plays an important part here. It is often tempting to go after the latest buzz and invest in an asset class that has performed the best recently, like equities and real estate in India, till 2008. As people that bought stocks or real estate – for investment- in early 2008 will attest, this can be a recipe for financial disaster. Putting all your eggs in one basket is seldom a good idea.

The basic idea behind diversification is that different asset classes react differently to economic events. For instance, when an economy is contracting, corporate profits fall. Demand for office space falls too. This is bad news for stocks and real estate. Demand for money comes down and interest rates fall, pushing up the bond prices, which is good news for those investing in debt. Similarly, when an economy is in the upswing, the reverse could happen, when stocks and real estate outperform debt. Thus, there are times when one asset class does better than the rest. As almost no one can time the entry into and exit from asset classes successfully, it may make sense to diversify across asset classes.

The asset classes 

The asset classes that an individual investor most commonly looks at are stocks, real estate, gold

 and debt – including cash. Please note that I don’t include insurance here as I don’t look upon insurance as an investment. Insurance is protection against unforeseen events. So, include the cost of insurance in your expenses. Don’t look upon that as an asset.

There is no magic allocation formula – that says x% should go into equities, y% into debt and so on. Be extremely wary if your financial planner uses a pre-built model to calculate the asset allocation for you. It makes no sense and it amazes me that almost all financial planners take this route. I am making this statement based on my personal experience.

I was once sitting with a seriously rich guy and there were these banks presenting to him, proposing to help him manage his money. One of the banks suggested that he should have 40% of his money in debt, as he was 40 years old! A number of planners use this thumb rule that one should have (100-x)% in equity and that was what this banker was using. This guy was worth many a million dollar at that point in time and 40% of his wealth in debt would have given him interest income which was probably 10x the amount of money he expected to spend annually. That would have been an extremely sub-optimal arrangement. If this is the depth of analysis that the planner was willing to do, when they were dealing with such a rich person, you can imagine what kind of thought goes into planning support for you and me. So, you need to take charge and make sure that your planner explains to you why he is suggesting a particular model. Make sure that you are comfortable with the same.

Once you have decided on the asset allocation, you need to make reasonable assumptions about the kind of returns you should expect from each one of the asset classes you would have decided to invest in. As Mark Twain remarked, “History does not repeat itself, but it does rhyme”. So, past returns over a reasonable long period of time – say over the past decade- should be a good indicator of the returns you should expect.

With your asset allocation decided and return expectations built in, you are on track to know how close you are to achieving financial freedom. I have designed a spreadsheet that lets you determine this. Please send a mail to investingforfinancialfreedom@gmail.com and I will happy to revert with the same.

I will discuss the rationale for investing in each one of these asset classes in subsequent posts. Till then!

Disclaimer

Please note that the information contained and provided in this blog is of a general nature and it is not my intention to provide any professional advice, solicitation or offer to sell, recommend or purchase securities and/or funds to the readers of this blog.

Please exercise due caution and verify any and all information sought to be relied upon and/or seek independent professional advice before entering into any commercial or business relationship or transaction with any person or entity, and /or any other party or make any investment or enter into any financial obligation based solely on any information, statement or opinion which is contained, provided, posted or expressed in this blog.

Please be advised that it is your sole responsibility to authenticate, verify and evaluate or take professional advice on the accuracy and completeness of all information, statements, opinions and other materials contained, provided, posted or expressed here or on any website with which this blog is linked. 

Saturday, March 21, 2009

Financial Freedom - the why, the what and the how

Financial Freedom – basic questions

I stated in my previous blog post that financial freedom is something I have been working towards, for a long time now. The words mean different things to different people. So, here is my attempt at defining what the words mean to me.

The why

Pleasure in the job puts perfection in the work - Aristotle

The way I look at it, answering the ‘why’ is probably the most important step in achieving financial freedom. It is the answer to this question that provides the motivation to embark on what could be a longish journey.

Speaking for myself, I have always envied the entertainers – athletes in particular. Here is a set of people that do what they love to do and get paid handsomely at that. For the rest of us, achieving financial freedom and going on to do what one would love to do is the best shot nirvana.

Top notch quality output comes out of a sense of inspiration and love for what one does. And usually, ones makes a lot of money – if that’s the intention – doing what one loves to do, as the world is happy paying for inspired work. A win-win situation, no matter how one looks at it.


The what

So, what does financial freedom look like? My definition of financial freedom is that it’s a state where I have the option of deciding not to work for the monthly paycheck, without threatening my lifestyle. So, if one’s passive income is such that it covers expenses needed to cover one’s lifestyle, one can lay claim to having achieved financial freedom.

One needs to set aside a certain amount of money, the nest egg, to earn the passive income. Clearly, the nest egg that one needs depends on one’s lifestyle – the spend part of the equation – and the returns on one’s investment – the income part of things. Of course there are issues like the expected returns from investments and the rate if inflation one would have to contend with.

I have designed a spreadsheet that lets one calculate the amount of money one needs to support a given spend, subject to assumptions around the factors mentioned above. Drop me a mail at investingforfinancialfreedom.com and I will be happy to send a copy of the same to you. You can change the assumptions mentioned in there and see what works best for you.

The interesting bit is that most of us don’t need anywhere near the kind of money that we think we would need, to maintain current life styles.

The how

This is the easy part. Draw up a personal balance sheet, listing out your assets – all assets excluding the primary residence - and liabilities – all loans. Also compare your current income with the expenditure pattern and see what kind of money you can out aside on a regular basis. Decide on a proper asset allocation – something that’s in keeping with your appetite for risk. Make assumptions about the returns you should expect. Do your math with the above and you will know how many years of toiling lie ahead of you. The spreadsheet that I spoke of above can help you do the math.

I would strongly suggest that you use the services of an honest and trustworthy financial planner to help layout a financial plan that you could use to achieve your goals. When you do that, make sure that you know what the financial planner expects to get paid and how. More often that not, the financial service providers – the mutual funds and the insurance companies – pay the financial planners for selling their products to you. Make sure that you know what the amount is and you think the same is fair.

And please make sure that you are adequately insured, as you go about doing the above. 

I intend to discuss the various aspects of drawing up and implementing a financial plan in my future blogs.

Disclaimer

Please note that the information contained and provided in this blog is of a general nature and it is not my intention to provide any professional advice, solicitation or offer to sell, recommend or purchase securities and/or funds to the readers of this blog.

Please exercise due caution and verify any and all information sought to be relied upon and/or seek independent professional advice before entering into any commercial or business relationship or transaction with any person or entity, and /or any other party or make any investment or enter into any financial obligation based solely on any information, statement or opinion which is contained, provided, posted or expressed in this blog.

Please be advised that it is your sole responsibility to authenticate, verify and evaluate or take professional advice on the accuracy and completeness of all information, statements, opinions and other materials contained, provided, posted or expressed here or on any website with which this blog is linked. 


Saturday, March 14, 2009

Investing for financial freedom

The other day I met a batch mate from B-school, who has been working for a bulge bracket i-bank in the US for close to a decade now. He looked distraught. We got talking about the scene on Wall Street. Turns out that his job is safe, at least for now. What was bothering him was that he had to postpone his plans of returning to India for a while. He badly wanted to get back to India, for personal reasons, and not being able to do that was hurting.

I suggested that he should consider coming back and the nest egg he would have built up should support him and the family till such time that he found a job of his liking here. Apparently, he did not have a big enough nest egg! That was a bit of a shocker to me. Somebody that was earning the kind of salary that many of us can only dream of, did not have a big enough nest egg- after ten years of working! Turns out that he had invested all his money in ‘safe’ money market funds, for the first several years of his stay in the US. About a couple of years ago, he had bought a house and had pumped in a significant part of his savings into the down payment for that house. With the bursting of the housing bubble there, his home equity had almost evaporated. What was left in the money market accounts did not make him feel confident enough to think of a comeback, as he was not sure of landing a job quickly, on return.

While I did not have the heart to tell him so, I see that there are many things that he did wrong. The instrument he chose to deploy his savings in – the money market mutual funds – was a wrong choice. It guaranteed the return of the money he put in, but did little more. He could have afforded to take a few more risks, do equity investments – remember, when he started off the markets were in a bad shape and he would have had a few years good run. He bought into his house at the wrong time, when the housing market was a huge bubble. He could have avoided a lot of these mistakes and done better with his investments, all without the benefit of hindsight.

I am not getting into the timing of his actions here. It’s almost guaranteed that anybody that tries to time any market will fail. What I am faulting are the beliefs that drove his actions.

He opted for safety, when he had the luxury of a longish investment horizon. In spite of seeing the housing markets bubble over, he bought into his house because he thought real estate never does badly over time.

I see many of us doing similar mistakes, which come in the way of our achieving financial freedom, the freedom to do what we want to, without bothering about the next pay check. This blog is my attempt at initiating a dialog with the readers about the best ways of getting there, achieving financial freedom. I expect that some of the readers will benefit from the insights I bring in, in the realm of investing. I hope to learn too, from those that know better than I do. 

I have been obsessing over financial freedom for close to a decade now, and we – I and the wife- have convinced ourselves that we are there, or at-least almost there. It’s a fun feeling. I believe every hard working individual deserves achieving financial independence. I also firmly believe a lot of people can achieve this, with the right information and knowledge. This blog is about sharing such information, and developing such knowledge

This blog will be limited to discussing financial planning and investments – both equity and debt. Equity investing is something that is very close to my heart and something that I am constantly working on, with the hope that I will get better at it with time. So, expect to see a lot of discussion on that.