Investment Objectives & Advice, Mutual Fund

Portfolio Management: 7 ratios to measure your risk capacity

You would have heard this many a times that your portfolio construction and choices should be aligned to your risk capacity and appetite. While appetite is a qualitative behavioral assessment, Risk capacity is more mathematical in nature. You can assess it based on certain numerical aspects of your own financial status. In our last write up “How much equity should you hold?“, we spoke about four pillars to decide the equity holdings Risk Capacity, Risk Appetite, Time horizon and Market valuations. In the next few weeks we will talk about these parameters in detail and how to rank yourself on these. Before calculating the ratios, you should know about your financial standing. This is defined through 4 major parameters below, Please keep calculating these for yourself to make the process more fruitful.

A. Take-home Salary/ Income: This is an easy parameter, most of the salaried people know their net take home salary as this is what gets credited to your account on a monthly basis. If you are a self employed person, you need to look at your gross income after reducing the professional expenses out of your total revenue/receipts. In case of salaried employees, you just need to make one adjustment for provident fund as your and employee contributions to EPF is your saving only and will be paid out to you therefore should be added back to your net take home salary.

B. Expenses: Some of us are in habit of keeping a good track of our expenses and some might be in habit of writing those on a daily basis. If you do not, then you can asses based on top of your head basis and reconcile it with you cash outflow from your account or statement of your credit card etc. Expenses are classified broadly in two categories:

  • Mandatory/ Necessary: These are common household expenses like house rent/ home EMI, house maintenance, Monthly grocery expenses towards grains/ veggies/ milk etc, Utility bills (Internet, Phone, Water, Electricity), Transport expenses (including Petrol, car maintenance, insurance etc).  These can be assessed with certain accuracy and ease.
  • Discretionary: These are not necessary one but important to unwind ourselves from our hectic schedules. Dining out, watching movies, buying games, books, for some it is un-necessary shopping, short or long holiday trips etc. Most of these will be easy to ascertain via CC but these are not regular so you might need to think broadly in a yearly fashion to calculate these or reach to a correct amount.

C. Savings/ Assets: This is something which is usually not at all tracked by most of the investors. Lot of people are very good in saving but saving for them means, only not-spending and keeping the amount in savings account. They can probably at best go buy LICs after a push from a sales person or do some fixed deposits or Post office schemes. Our parental generations commit the mistakes of just saving and not investing, which we should aim not to repeat (Link). In most cases, we are not aware of our overall assets and should be recorded at-least once in a year. Assets are broadly split into two categories:

  • Financial Assets: Assets which are invested in financial markets or with financial services firm are called financial assets. Investments like Deposits, NSCs, Post Office investments, PPFs, EPFs, Mutual Funds, Stock investments, Bonds, NCDs, ULIPs, traditional insurance are all form of Financial assets. The unique feature of financial assets is that they can be liquidated in short period of time at relatively fair market value.
  • Real Assets: Assets like real estate, plots, Gold jewelry etc are form of real assets as you can touch and feel these assets vs Financial assets which are just on paper. The challenge with real assets are large ticket size and difficulty to sell in parts, you can  not usually sell a room only of the flat you own.

D. Liabilities: This is the amount you have borrowed from various institutes/ people, in form of Credit Card bills, home loan, car loan, education loan, personal loan etc. The credit is so easily available that we often start indulging ourselves in consumption which is not required. This is a common mistake in our generation (link), which traps us in the mediocre life status. Keeping a track of your liabilities is very important.

The benefit of doing this exercise is that you can keep at-least 1 additional person aware of all your Assets and liabilities to help your family navigate the financial difficulties in case of any family emergency.  Secondly you are more aware, so have better chances to succeed financially by knowing your limitations as well as short comings, you can change your financial behavior. There are 7 ratios which helps to determine your risk capacity in terms of financial status based on the above details.

  1. Savings ratio: The more you are able to save, you have more capacity to take risks. usually 60%+ saving ratio is considered to be very good.
  2. Expense Coverage ratio: High Net-worth compared to your Annual expenses is a healthy sign. Higher the ratio, higher the risk capacity.
  3. Income Multiplier: Higher net worth compared to annual income is sign of the investment career cycle. Better the multiplier, higher the risk capacity.
  4. Leverage ratio: As mentioned previously, the lesser liabilities we have the better it is, Though sometimes it make more sense to take loans specially in case of appreciating assets like education/home etc. Liabilities/ Assets are lower the better for risk capacity.
  5. Liquidity ratio: If you have high allocation to real assets, which are less liquid in nature. it makes it difficult to meet your financial needs in case of emergency. This should be captured in two forms. Financial Assets/ Total Assets & Financial Assets/ Liabilities, higher the ratios better it is for risk capacity.
  6. EMI Coverage ratio: Total EMIs/ Take home Income should be measured to calculate the pressure of EMIs on financial health. The lower the value better it is for risk capacity.
  7. Income Stability: This depends on how many households are earning members, if 2 people in family of 4 are earning it is better vs 1 person.  There might be cases when all 4 are earning members specially in case of people in their 50s when their kids also start earning. Their risk appetite increases as a household vs common philosophy that with age risk capacity reduces.

Based on these ratios you can assess your risk capacity (Working Spreadsheet; Please fill in the cells highlighted in blue color) and vice versa check how much equity should you hold in your portfolio (Link).

Read more on Mutual Funds and Retirement planning. Happy Investing!!

Investment Objectives & Advice

Retirement Planning Part 3: Adjusting for Lifestyle Inflation

One common question i received over last few weeks is “Why are you focusing on retirement planning?”. I started with counter question, what other goal you want to plan for? Answers ranged from buying a car, buying a house or going for foreign trip, Child education etc. This made my reply simple, Have you heard of Car Loan, Home Loan, Education loan, Personal Loan? But Have you heard of retirement loan? During our retirement years, we are having limited future earning potential, Physical energy and fitness. Also, We should aim to have a peace of mind. Do you agree? If yes, Let’s continue.

In part 1 (Know your retirement corpus), we discussed about how to calculate your required retirement corpus. In Part 2 (Build your Retirement Portfolio), we talked about the type of funds to invest, based on corpus required and time horizons. Today onward we will talk about various risk in retirement planning and how to mitigate them. Due to increasing awareness, people have understood inflation but do you know two types of inflation?

Price & Lifestyle Inflation:

Inflation or Price inflation refers to rising price of products. 5 years back, If you were buying milk for Rs 30-35 per liter, probably today you will be paying Ra 40-45 per liter. In other words, If you were able to manage the household expenses in Rs 10k a month, today you will need Rs 12-15k a month. This is due to increasing prices of Fuel, Rentals, Grocery, Vegetables etc. As RBI now targets to manage this inflation, we can safely assume that it will stay in range of 5-7% over the next 5-10-20 years and hence can be planned for. This is uniform for all of us and we already adjusted for this, In part 1 (Know your retirement corpus).

Lifestyle inflation is more personal in nature and varies drastically. This is very high in the starting period of your career as you go through a lot of changes in your lifestyle. E.g. 10 years back, I depended on tiffin services for my food at Rs 20 per meal in turn Rs 1,200 to 1,500  month. with 5-7% price inflation this should have doubled to Rs 2,500 to 3000 a month. Though in reality, Now I try to eat from a better place, also order food from outside more frequently and occasional fine dine outings have moved my food bill to Rs 12k to 15k a month, which is growing by 8-10 times in 10 years. This is because of Lifestyle inflation.

Similarly, Now i will prefer travelling by flights or A/C coaches vs Sleeper or general class in trains. Prefer to stay in gated society in 2-3 BHK flat vs Individually rented rooms/sharing accommodations. Prefer to take a cab vs local buses, prefer to go to multiplexes vs watching a downloaded movie etc. These are all examples of Lifestyle inflation and should be there as your capacity to earn and earning rise over the years.

How to plan/ adjust for Lifestyle inflation?

We should definitely not devoid ourselves from the pleasure of buying the desired watch or go for the long due foreign trips but still make sure that it should not derail our retirement plan. There are two ways to keep the risk form lifestyle inflation in check.

  1. As the earning power increases, with your income, your expenses and savings should increase in similar proportions. Means, if your salary increases by 10-20% a year so should your investments. This will keep our expense ratio to income constant which should decrease after 10-20 years of working life as the growth of expenses should slow down.
  2. As the expenses are growing by not only by price inflation, Every year you should review your retirement portfolio requirement and investments need based on latest expense.

Read more on Mutual fundsRetirement Planning. Happy Investing!!