Application of Portfolio theory in real life

We all do financing planning, knowingly or unknowingly, either on a broad macro scale or at a micro level. In a typical Indian household, where the man is bread-earner and the lady of the house allocates money daily for essential cores, that is financial planning at the micro level. The financial planning we are talking about is here i.e. application of portfolio theory in real life, is taking the major financial decisions of the family on a rational basis as well as questioning the area that require financial planning but have been left unattended. It is more important to manage the pounds than pennies. Resources are limited, but planning within limited financial resources leads to prioritization of goals i.e. the measurable goals of life. The theoretical concepts of portfolio and diversification that we discussed in Chapter 10 may not be practically applicable to all real life situations. You are obviously not expected to chart out a mean variance frontier before you decide on allocating money between equities and fixed income securities. However, the theoretical concepts can give you a general guideline on how and why you need to satisfy investments. In the discussion that follows, we have given four cases of lack of pragmatism in investment decision committed by common investor. The first two cases are more elaborate and focussing more on managing the entire investment portfolio. The third case speaks about how fixed income securities become important vehicle at later stages of life. The fourth case is more focused on how to manage your investments within fixed income space.

Case 1 Dweep and Radhika Shah

Dweep and Radhika Shah are both 32 year old and live in Mumbai. They have a 4 year old son named Kshitij. Both Dweep and Radhika work at Private Sector Bank and earn about Rs50,000 each per month. Their current household expenses are about Rs25,000 each per month and in addiction they make purchases on credit card worth about Rs30,000 each month. Dweep is in habit of not paying the full balance due on credit card and pays only the minimum 5% of the balance and revolves the outstanding to next month. His argument was that Why should he pay up in full when he needs to pay only 5%? In addition, Dweep has, earlier in this, purchased a new luxary car worth approximately Rs850,0000 for which he has taken a 5-year car loan of Rs 500,000. Dweep has to pay monthly instalment of Rs17,500 in respect of this loan. Further the Shahs currently stay in rented premises paying Rs35,000 each month but intended to buy a few house in the city on four-five years time. They estimate that they will have to avail a home loan of approximately Rs40 Lacks and that the monthly instalment in respect of his loan would be about Rs 40,000-45,000.This house will cost them approximately Rs50-55 Lacks.

They paln to enrol their son Kshitij in an international school next year and expect to have to pay about Rs60,000-80,000 in fees each year. Dweeps parents are aged and do not often keep good health. Dweep wishes to bear a part of their house hold expenses and also keep aside some fund for their healthcare. He expects that their healthcare bills will rise in the coming years and plan to keep aside at least Rs50,000 each year towards medical expenses. Further Radhika is fond of travelling and would like to take at least one long vocation each year. She wants to keep aside about Rs75,000 each year for their annual vacations. The Shashs currently have about Rs500,000 in fixed deposit in a Bank and have a provident fund balance of another Rs500,000. In addition, Dweep has some investment in Equities and equity mutual funds whose current market value is about Rs250,000. Dweep does not make any study of market nor does he seeks any professional advice. He often has sometimes earned in the equity market but has equal market but has equal times lostmoney in bad investments. The Shahs have taken a life insurance policy which will mature in the next 15 years. Currently, they have to make an annual premium payment of about Rs50,000 each on policy of Rs5 Lacks. Dweep and Radhika are receiving their finances and are worried that they may not be able to meet all their finances demands. They are also worried that they may not be able to meet all their financials demands. They are also worried that they are not saving enough and do not have an adequate investment portfolio to fall back upon in times of need.

Restructuring/Suggestions:
1. Reduce the Credit Card debt burden Dweeps actions of the past, of outspending their incomes levels and more so of not trying to repay the credit card debt have led to a huge accumulated debt that would be difficult, if not impossible to pay off in null. Dweep is now realizing the folly of the concept of minimum pay on the credit card billing. His total accumulated outstanding is now over Rs5 Lacks. So, the first thing that they should focus on, is to ensure that they reduce this debt burden to zero in the next few months. One of the ways to drastically reduce this debt burden is use that fixed deposits that they have. It may sound imprudent to you at first, but look at it this way- the interest that they earn on the fixed deposits would be around 8% while the credit card company would be charging about 2.5% interest per month (or roughly, about 30% a year )! This brings us to a very important concept of managing money: every penny saved is a penny earned. It would be better be better to pay off the credit card debt and save on rising burden than to keep money in bank deposit.

2. Keep a Contingency Fund Trouble does not knock your door before coming. It always prudent to keep at least about 6month household expense as a reserve in liquid form .Since their household expenses are about Rs60,000 a month (Rent expense of Rs35,000 and other household expense of Rs25,000), they should target to have at least about Rs3.6 Lac in liquid asset at all times . It would be difficult to build this in day and hence they should target to build it up in the next few (say, six) months. They can keep this money partly in their savings account and partly in their good liquid fund. Both these avenues ensures that you can withdraw money quickly and your investments is devoid of risks in the normal course. While saving rates have been deregulated and there are several banks willing to offer a high interest rate on saving account, the liquid funds still have an edge over savings account from the point if view of taxes. 3. Health is Wealth While deep is worried about the rising medical cost of his parents, he should not miss out on the fact that he also need to consider his own health as well as that of his family members. Dweep must but a health insurance cover for all his family member and a family floater policy would be a good option to look at. A family floater policy would cover the medical bills of all the members of his family, including his ageing parents. It would act as an umbrella policy and would be cost effective than buying five different policies. More so, the Shahs can consider keeping the total cover on the higher side this would cover the cost of any severe illness suffered by any member of family. Any premium paid on health insurance will allow tax savings such as payments are eligible for deduction in computation of taxable income (currently under Section 80D of the Income Tax Act). 4. Goal of buying a house The shahs plan to buy a new house in about 4-5 years. This will require them to pay about 2025 % of the flat cost as down payment. Thus a Rs 50-60 Lack house will require them to pay about Rs 10-15 Lack upfront. This money cant be generated overnight. The shahs will have to start saving today so that such a corpus gets built up over the next 4-5 years. A good option this corpus would be to invest in a recurring deposit account with Bank. They can invest about Rs 20,000-Rs 25,000 a month in a 5-year monthly recurring deposit. The corpus built over the next 5 years would be sure to suffice their down payments needs, and the interest earned on the recurring deposit would cover the inflation factor over the next 5 years.

5. Life Insurance and pension plans A cover of Rs 5 lac for a person earns an income of Rs 6 Lac per annum is too less. The insurance cover is like a replacement to cover your human life. Considering the income level of Dweep and Radhika, each should have an insurance cover of not less than Rs 75 Lac. This would increase their premium cost per annum, but that is necessary cost and not prudent to be neglected. In the case of shahs, Term insurance product would be better tha a market linked product since it will be lower on cash outflow and they have several other commitments to meet. Moreover, each of would get tax benefit of upto Rs 1 Lack on the premium that she or he pays, which would help reduce tax burden a bit. Further, it is never too early to start planning of your retirement. It is important that the shahs but a pension plan that would take care of their retirement needs. There are several innovative products available in the market today that provide a life cover as well as pension benefits and it would be right time for them to start looking at these options. This will ensure that the combined cover along with the term policy will be upto the requisite level. 6. Saving Habit Habits take time to develop. The shahs are young and it is time for them to inculcate the saving habit. Dweep and Radhika together earn about Rs 1 lack each month. Assuming that about 10%15% of his income would go in taxes (considering slab limit available for each one of them), they would be earning about Rs 85,000 to 90,000 post tax. However, they planned savings are zero as of today. They make to make a correction in this and ensure that they decide and keep aside some money each month as savings. By buying products that require periodic commitments such as recurring deposit for their house plans and pension and life insurance products for securing their future, they would get into a habit of saving money. Such commitments would also act as a deterrent from impulsive shopping habits.

Case 2 Prashant and Sneha Shetty

Present Situation Prashant and Sneha Shetty are both in their early 40s and live in Banglore, India. Prashant work as a software engineers in a mojor IT company while Sneha teaches at a local school nearby. They have a 7 year old daughter named Neha.

Prashant earns about Rs 85,000 a month while Sneha earns about Rs 25,000 a month. Prashant has a hectic working life and wants to retire at the age 60. He wishes to have a retirement portfolio ao at least Rs 2 crore. Their monthly household expenses are about Rs 25,000. They usually spend about Rs 50,000 each year on one or the other house hold purchases like electronics, furniture, tec. They also spend about Rs 50,000 each year on Nehas schooling and tuitions. Prashant suffer from blood pressure and Rs 25,000 in a year. The Shettys currently live in two bedroom apartment in Bangalore on which they have housing loan outstanding of Rs 20 Lakhs. The loan would get paid off in the next 8 years. Prashant wants to buy a farm house on the outskirt of Bangalore and spent his retirement days there. He would like to purchase a land in next ten years and then design and construct the house himself. He estimates, based on todays land and construction cost that he would have to spend upward of Rs 50 Lakhs to get his dream farmhouse ready. Sneha would want that they, as far as possible, fund this farm house themselves and not take any additional loan. The Shettys currently drive a 4- year old small car that they find easy to use in city traffic. However, they love travelling a lot and would want to buy a SUV worth about Rs Lakhs to enjoy their weekend trips. They wish to buy this bigger car in the next 5 years. They also want to be able to take foreign vacations once every three years. Further Prashant want to keep aside sufficient money for his daughters education and marriage. He estimates that they will require about Rs Lakhs (by todays standards) in about 15 years for their daughter higher studies. Prashant also fell he would need another at least Rs 7 Lakhs (at todays price) for spending on their daughters marriage after 20 years. Sneha wants to be able to give about Rs 1,00,000 each year to give donations to various religious charities of her faith. She also run an NGO to teach underprivileged children in the city and also sponsors their school tuition fees and books. Prashant donates Rs 50,000 each year to s\Sneha charity and wants to continue to do so in future. If possible, he would like to donate at least Rs 1,00,000 each year to her NGO. Sneha does not believe in lavish lending and likes to save as much as she can. She targets to save at least Rs 30,000-Rs 40,000 each month. The shettys currently have bank fixed deposits of about Rs 20,00,000 and another Rs 7,00,000 in Public Provident funds. While Prashant feels that he could equally earn good returns if they invest their savings in equities, Sneha believes that equity markets are too volatile and risky and therefore advises Prashant against investing their hard-earned money in the equity market. Further, Prashant does not find enough time to analyse equity investments. In sum, the Shettys have always stayed away from equity investments. This being said, Prashants company recently allotted stock options to its employees, in which Prashant too chose to participate. His company has ben doing very well and its stock prices have increased significantly in the past one year. Prashant believes that if he were to encash his stock options today, he would get about

.10,00,000 post all taxes. However, the options are subject to a lock in and Prashant would not be able to sell the shares for at least the next 3 years. Prashant has purchased a term life insurance policy in the name of Sneha for which he pays about .40,000 as annual premium. Prashant has recently purchased a ULIP from a private insurance company for which he pays an annual insurance premium of .200,000. The ULIP will mature in the next 10 years with a sum assured of .15 lakhs. Prashant and Sneha are bothered that although they have a respectable investment portfolio, it would fall short of their objectives for their daughters education and marriage as well as for their own retirement.

RESTRUCTURING/SUGGESTIONS
1. Generate funds for farmhouse The Shettys can use ULIP as a tool to meet two different objectives: one, the insurance plan will ensure a life cover and two, the ULIP payments will also act as an investment corpus, which can be used for purchase of the land and construction of farmhouse in future years. ULIPs usually give you a basket of a few alternative investment funds to match your needs. Since the Shettys have a low willingness to take risk they can choose a debt oriented fund to invest in. 2. Retirement Income By the time Prashant retires, he would have a self-owned (his housing loan would have been repaid) house in a megacity like Bangalore and also a farmhouse on the outskirts of that city. Property is a huge asset these days and Prashant can monetize his asset by opting for a reverse mortgage. A reverse mortgage will ensure that they earn a regular income in their retirement days.

3. Saving money for daughters marriage One of the biggest expenditure in marriage would be jewellery. Prashant and Sneha can in fact start investing in Gold today so that they build a respectable value of Gold by the time of Nehas marriage. Instead of buying physical gold, they can invest in Gold ETFs or a Gold Fund. One of the main advantages of a Gold Fund would be that they can schedule an SIP with the fund which will ensure a hassle free saving and investment. 4. Health protection Prashant suffers from a few ailments as of today and it is very important that he buys a good health insurance plan. This will ensure that in case of any hospitalization, he would not have to bear the burden of long medical bills. There are several health

insurance plans available in the market today and Prashant and Sneha can scout for and identify a plan that best suits and meets their possible health care cost. 5. Diversity risk from employer One of the basic principles of investment, as discussed in the earlier chapter is that of diversification. Diversification need not necessarily be between asset classes alone. Here, we discuss about diversification in a different sense. Hypothetically speaking, what happens if you hold a major portion of your investments as employers equity? Suppose for a while that the employer gets into financial trouble. In such a case, you might lose your job and at the same time, your investments will lose in value. SO, your investment would not be of any help, just when you need them the most. To avoid such a scenario, it is better to gradually reduce the investment in allotted equity under ESOPs once the lock-in period expires and invest it in other good investment avenues. 6. General investment decisions In general, keep in mind the investment thumb rules: For a very long horizon, it is better to invest in a well-diversified, wellmanaged, Large Cap Equity Fund by way of an SIP For the medium term goals, we recommend Bonus Funds Long Bond Funds, Short Term Bond Funds, Monthly Income Plans

CASE 3 Paresh Mehta

Paresh Mehta is a 65 year old retired businessman. During his working years, he acquired significant wealth and he is now happy and content with his life. His total invested corpus today is about 25 Crores. Paresh has two sons who now looks after their family business. The family is well off and there are no pressing financial goals. Paresh would like to leave as large a legacy as possible for his grandchildren. Being in the high net worth segment of investors he is often advised on investment opportunities by various investment professionals. Paresh has always had an appetite for risks, be it in his business decisions or his investment decisions. During his earlier years, a majority of his wealth was invested in equities based on the recommendations of his investment advisors. Even as of today, about 20 crores of his wealth remains invested inequities while the balance is invested in bank fixed deposits. Although he has largely gained from his equity investments, the incessant fall in markets in the last few years has made him quite worried.

Paresh has just received a call from an investment advisor, who was trying to advise him into buying equity of an infrastructure company. The advisor explained to him that the stock has fallen significantly of late and was available at almost rock-bottom prices. He further told Paresh that his research team has issued a confidential report that this stock is expected to almost double in value in the next one year. Paresh has about 2 Crores available for additional investment and the prospect of earning such a high return is very appealing to him.

Restructuring/Suggestions:
In the investment industry, especially in relation to investment by individual investors, the interplay between financial wealth and human capital is most important. Human Capital is the earning potential of an individual over his lifetime, measured in terms of present value. At the early stage of earning life of an individual (when he has finished his formal education and is to begin his career) his human capital is at its highest point. However, at this stage, his financial wealth is usually at its lowest point. As the individual ages, his future earning potential decreases while his financial wealth increases (through accumulation and returns). When the individual finally retires, his human capital is almost completely depleted while his financial capital is at its highest point. This interplay is depicted graphically as below. Figure 1 Interplay of Human and Financial Capital

Amount

Human Capital

Y-Values

Financial Capital

Age

Our total wealth, at any point of time, is not merely our financial capital but in fact, a combination of our financial and human capital. Thus, when we begin our career, our human capital dominates our total wealth while when we retire, our financial capital dominates our total wealth.

If you look at this interplay from a diversification standpoint, investing the financial capital in equities at an early stage in our life would be acceptable since this relatively risky asset forms a relatively small part of our total wealth. However, as we age, our financial wealth becomes a larger and larger component of our total wealth and this is a reason important enough to ensure that it remains relatively less risky. Fixed Income investments are relatively less risky as compared to equities. Therefore, in the retirement stage of life, it is always advisable to invest your financial wealth in fixed income securities rather than in equities. Coming back to the case of Mr.Paresh Mehta, it would now be much easier to review his investment portfolio. Of the . 25 Crores of his investment corpus, 20 Crores is invested in equities. This means 80% of his financial wealth (and since at his age financial wealth forms a significant part of his total wealth, nearly 80% of his total wealth) is invested in a relatively risky asset. This means his total investment corpus is not well diversified and is highly skewed towards equity. His actual investment diversification should have exactly the opposite i.e. 80% or more of hi investment corpus should be invested in fixed income securities and the balance in other assets. There are several complex financial models used by investment advisors to arrive at the percentage of investment that should be made in equities. However there is also a thumb rule that the industry follows to arrive at the percentage of investment corpus that should be invested in risky assets like equities. The rule is 100 age. So, an individual who is say 25 years old, should invest 75%(100 25) of his corpus in equities and the balance in fixed income securities. As the individual ages, the percentage of investment in equities would reduce. As for Paresh, he should invest not more than 35% (100 65) of his total investment corpus in equities. As for the additional investment of 2 Crores, it would be better if he invests that amount in fixed income securities rather than equities. This will automatically reduce his equity investment percentage. At the same time, he can gradually reduce his equity exposure and move to fixed income products. Even within the fixed income space, he can have several investment avenues based on his financial goals. We have discussed in the previous chapters about various market-linked return products such as Liquid Plus, Short Term Bond Funds, Long Bond Funds, etc. as well as several contractual return products such as Debentures/Bond, post office schemes, etc.

CASE 4 Chintan Desai

Chintan Desai is a branch manager in a public sector bank and is 50 years old. He is very conservative in his investment decisions and invests only in fixed deposits. He usually opens fixed deposit accounts at the end of the year and selects medium tenure of 5-7 years. Over the

past few years, the interest rates on fixed deposits have been fluctuating and Chintan has sometimes felt that he has unnecessarily locked his funds for a significantly long period of time. Chintan currently has a total investment Corpus of 45 lakh and the entire amount has been invested in bank fixed deposits. A majority of this amount was invested a few years ago and earns interest at only about 6-7%. Most of this money will not mature for the next 3-4 years. Withdrawing his deposits now will attract premature withdrawal penalty and will wipe out most of the additional interest that he would earn. Chintan is currently seeing banks offer interest rates in the range of 8-9%. He feels he has missed an opportunity to invest his money and earn this higher rate of interest. However, he has been reading in newspapers and hearing investment experts on TV say that the interest rates will fall in the coming months. If that were to happen, his future investments will again get deposited at a lower rate of interest. He feels he has missed out on a good opportunity to earn higher rates because of bad timing. He is very concerned about how should he ensure that he does not lose out on future rate interest rate increases while at the same time ensure that if interest rates were to fall, his subsequent investments do not get reinvested at very low rates.

Restructuring/Suggestions:
The best solution to Chintans dilemma is to apply the financial concept of laddering. This will ensure that the return his bank deposits earn is averaged over peaks and troughs of interest rate movements and that his overall returns are averaged and steady. The concept to laddering can best be explained with an example. Lets assume that Chintan would like to invest 4 lakh this year in fixed deposit. In this case, he should avoid investing it for a long period of five or seven years, but instead divide it into four different parts and invest each part for one year, two year, three year and four year respectively. This will ensure that there is a deposit maturing at the end of each year for the next four years. He can then invest each maturity proceed in a new fixed deposit for a period of 4 years. To show you graphically, the laddering process will work as below:

Now that we plan to invest 4 lakh in fixed deposits, instead of selecting an arbitrary period of say 5 or 10 years, you can opt of the laddering process as below: Invest 1,00,000 in four different fixed deposits for a term of one year, two years, three years and four years respectively. On maturity, invest the maturity amount in a four year fixed deposit. This will ensure that there would be cash flows in each year. This will also ensure a steady liquidity in the fixed deposit investments.

An example of how this process might work is shown below: For the sake of explanation, we have considered: 4 lakh is to be invested today Fixed deposits are cumulative No impact of tax is considered As an alternative to laddering, the money is deposited in 5 year fixed deposits Interest rates are the same for fixed deposits of one year or five years The investment horizon is chosen as 25 years. In case of laddered deposits, last investments are made in deposits such that they will mature in the 25th year The Investment/Re-investment rate in each year is the rate at which you will earn interest if you were to invest in fixed deposits in that year. (For example; if you were to invest in a fixed deposit in the 5th year, you would earn interest at 11%) The interest rates are shown to fluctuate each year. These fluctuations are purely hypothetical.

Table Investment/ Reinvestment rate Year 0 1 2 3 4 5 6 7 Laddered Investment Deposit 1 100000 10800 Deposit 2 100000 118810 125971 136049 146933 167710 184434 Deposit 3 100000 Deposit 4 100000 Single Investment in block of 5 years 400000

8.00% 8.00% 9.00% 10.00% 10.00% 11.00% 11.50% 10.00%

Total Deposit 400000 10800 118810 125971 136049 146933 167710 184434

587731

8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

9.50% 10.00% 8.50% 8.00% 7.00% 7.50% 8.00% 8.50% 9.00% 9.50% 10.50% 10.00% 9.00% 8.50% 9.50% 9.00% 9.50%

199189 223054 259214 270030 286367 326574 359234 367373 375368 436129 488734 509128 529863 627006 728654 745414 868942 956674 885626 747944 818999

199189 223054 259214 270030 286367 326574 359234 367373 375368 436129 488734 509128 529863 627006 728654 745414 747944 3530241

990361

1489163

2239191

3445272

Note: Although in the hypothetical example above the corpus value on laddering is higher than the corpus value in case of 5 year deposits, this may not always be the case. The real USP of a laddered investment schedule is that you have funds maturing in each year which creates a potential liquidity in your hands. That means in case of any contingency need in any year, you need not prematurely withdraw a fixed deposit (at the cost of a withdrawal penalty) since you have a portion of money maturing in the near term (within a year). Further, the interest rate that you earn is averaged out so that there are no wide fluctuations in the interest rate over a period. Coming back to the case of Mr.Chintan Desai, he can apply this concept of financial laddering to his investment henceforth and also for his existing investments as and when they mature and are reinvested. With this, we conclude our chapters related to financial planning. In the earlier chapter, we focussed on the theoretical concepts of financial management and in this chapter; we focussed on the practical aspects. Nonetheless, its best to have knowledge of the investment theory as well as model practice. We are sure that you would have or will identify yourself with the characters in at least one of four cases in the course of your life. Be it in terms of the goals that these people had, the resources at their disposal or the investment dilemmas that they faced. If by reading the Chapters 10 and 11, you could arrive at a sound investment decision; if Chapter 10 made you remodel your investment portfolio to diversify it a bit, if Chapter 11 helped you make or remake your investment plan, our purpose of these chapters has been served.