How to save enough money, age no bar

I found this article pretty interesting about saving money.

How to save enough money, age no bar

Veena Venugopal with Kayezad E. Adajania | December 19, 2007

You might have read W. Somerset Maugham's classic short story, The Ant and the Grasshopper. In the story, Maugham, the master storyteller, turns the wisdom from an Aesop's Fable on its head.

The fable talked of how an ant that labours through the summer preparing for winter ends up a winner instead of the grasshopper who does nothing to prepare for the harsh months ahead. In Maugham's short story, Tom, the carefree but proverbial black sheep of his family, constantly gets into trouble only to be bailed out by his hardworking brother George.

Tom beats his brother's predictions of ending up in a gutter when he marries a rich lady, who, on death, leaves him a fortune, making him a winner and his brother a perpetually sulking loser. When it comes to real life, especially saving for the future, we all know that it is the fable's moral that works. The boring, but diligent, Georges triumph in the end.

How much should you save?

Whether you save regularly or irregularly, a question often comes visiting: "Am I saving enough?" Saving the right amount is crucial for at least two major reasons.

First, it is only when you save money that you can invest in options such as fixed deposits, public provident fund, stocks, mutual funds, real estate and gold to create a future income for meeting small and large requirements, such as the education and marriage of your children and your retirement.

At the same time, you need to step up savings as you move on in life. At the beginning of your work life, you do well to even cover your expenses. At this point, a small but consistent amount of savings is crucial. Often, taking some practical steps is all it needs.

By the time you get married, your income has risen, but so have the costs, as you get down to setting up your own establishment, which, among other things, often involves taking loans for big-ticket items such as cars and consumer durables.

This stage typically lasts till your mid-30s or early 40s, after which your income simply pulls away from your expenses. The reason is that expenses don't grow as fast at this stage and, in many cases, the growth slows down. This is also the time when your savings should be the maximum and get invested.

In your 50s, you could have to bear big expenses such as higher education and marriage of children, besides relocation preparations for retirement. But the rise in your income with salary increments and investment income will let you continue saving.

You can also step on the gas when the big-ticket expenses get over and reinvest the residual savings.

Why saving enough is half the job done

You can save a lot and yet be forced to be miserly when you need money. This slip between the cup and the lip can happen if you haven't invested your savings in the appropriate order to give it the right opportunity to grow.

On an average, Indians are saving more, but the savings are getting invested in lower risk-lower return options such as FDs and mandatory retirement funds such as provident fund and life insurance. Some investments of this sort happen by default. Employees' Provident Fund is a case in point, where 12 per cent of your basic pay gets stashed away every month.

Besides, the risk averseness of many Indian investors, lack of awareness of options that bring higher returns, absence of quality financial advice and, sometimes, simply lethargy makes people invest money in their savings account in fixed deposits of the same bank.

This is despite the fact that equities have been found to be providing the best returns among all asset classes -- 18 per cent compounded annual growth rate (CAGR) since 1979. For instance, if Rs 1 lakh (100,,000) was invested in the Sensex, a PPF and a 5-year bank fixed deposit in 1982, today you would get Rs 55.12 lakh (5.512 million), Rs 7.69 lakh (769,000) and Rs 15.07 lakh (1.507 million), respectively.

Thumb rules for equity investing

Thumb rule No. 1: (100 minus your age). If equity is the best bet for brisk growth of our savings, then the logical question is how much should we invest in them either directly or via mutual funds?

The standard rule of thumb to determine your ideal equity exposure is a simple formula that suggests you subtract your age from 100. For example, if you are 35, then 100-35 or 65 per cent of your portfolio should be exposed to equity.

While this can be taken as an indicative formula, it would not, of course, be applicable to everybody at every point in their lives. For example, if you are a 30-year-old and part of a double income family with one young child, you could put in 70 per cent of your investments into the market.

Thumb rule No. 2: Keep debt-equity proportion constant. If the age-based thumb rule does not apply to you, use a tactical allocation thumb rule. Here, you start off by investing, say, 60 per cent in equities and 40 per cent in debt, and continue keeping the ratio constant at all times.

If you find at the end of the year that equities have done well, you should trim your equity exposure in the next year, the assumption being that there is likelihood of a market downturn. However, in times of a long-running bull market, like the one we have been witnessing, this strategy may not be ideal.

Thumb rule No. 3: Factor in the trend. This thumb rule on trend-based asset allocation is the opposite of the previous one. The assumption in this one is that if the stockmarkets are going up, then that is the trend of the cycle, and you should enhance your equity exposure for the next year. Of course, trends could change and you might be trapped with a high equity exposure in a falling market.

How to follow the thumb rules. Since the thumb rules tend to contradict each other, you can adopt the following approach. Use the '100 minus age' formula if there is nothing exceptionally different in your profile and the assumptions fit you.

Keep that as the guiding number, and tweak it upwards or downwards depending on your specific circumstances. If you are in your mid-30s and single, you could invest more than 70 per cent in equities. If you are 60 and do not see yourself retiring for another eight years, you could invest more than 40 per cent.

How many mutual funds are enough?

Once you decide how much money you should place in equity, you need to figure out how much to keep in equity mutual funds and how much in stocks, if at all. Then, you will also have to figure out how many equity funds and stocks to buy.

The truth is that there is no magic number, though the number of funds in your portfolio should give you adequate diversification without making your returns suffer. Let's first examine mutual funds and then stocks.

How many mutual funds? You can target up to about 10 equity mutual funds. Apart from 10 being an easy number to track, academicians like J.L. Evans and S.H. Archer have shown in their research that most of the risk reduction due to diversification takes place in an aggregation of 8-10 securities.

Which categories of mutual funds? Typically, if you're venturing into equities for the first time, you can start with an exchange-traded fund (ETF). ETFs are low-cost cousins of index funds and invest in all the securities that lie in their benchmark index in the same proportion in which the index has them.

ETFs don't have risks associated with fund managers. They aim to give you returns in line with the market, so you don't lose or gain more than what the market does. Says Mumbai-based financial planner Jayant Pai: "It's not possible for active funds to outperform the market on a continuous basis. ETFs ensure that your returns are at least in line with the market." One ETF tracking a large-cap index like Nifty or Sensex should do fine.

Diversified equity funds. One ETF in your equity portfolio can be supplemented by a couple of diversified mutual funds, including equity-linked savings schemes. This will form the core of your portfolio and provide a baseline of expected growth.

As diversified equity funds invest in around 30-50 or in an even higher number of scrips, chances are the same scrip will feature in more than one fund if you have too many funds in your portfolio. Also, ensure that these schemes are different in styles. For instance, Franklin India Bluechip and SBI [Get Quote] Bluechip are similar in objectives, so it does not make sense to have both in your portfolio.

Mid-cap funds and thematic funds. You can supplement your core funds with higher growth investment options. One of them is mid-cap funds. Though there are 26 mid-cap funds in the market, almost all of them target the same universe of stocks and there are negligible differences among them.

Then, there are thematic funds that invest according to a theme, such as infrastructure. You can invest in one mid-cap and one thematic fund.

How many stocks are enough?

After gaining equity experience through equity mutual funds, you can invest directly in stocks. Financial planners believe there isn't much merit in holding top-line equities as they would be anyway present in your mutual funds.

"Target some good, small companies that your funds may not have," says Pai. Although Nifty has 50 scrips and Sensex has 30 scrips, you don't need to hold as many, as tracking would be a problem then. Here, too, 10 sounds like a decent number. "Ensure that these 10 scrips are from different sectors," adds Pai.

Winning the savings game is about succeeding in providing for the future without losing out on your present. It is here that thumb rules serve as great guideposts. They show a happy middle path that lies between the ways of the ant and the grasshopper. In the end, you still win.