Get more benefit by diversifying your investments

Financial Planning | admin | February 2, 2011 at 6:45 pm

I only want to invest in real estate. I think it is the best investment option,” says 34-year-old Mohit Agarwal, who is married to 33-year-old Krittika. The double-income couple live in Gurgaon with their three-year-old daughter and two-year-old son. Agarwals bring home an impressive six-digit salary of Rs 1.74 lakh every month, but their monthly investible surplus is only Rs 5,750.

The reason is heavy bias towards real estate as an asset class. The couple are serving two bulky home loans. Their investment approach has not only jeopardised the fulfilment of their financial goals in jeopardy but also deprived their portfolio of diversification.

Mohit, a software professional, earns Rs 1.25 lakh per month and Krittika, a doctor, has a monthly salary of Rs 49,000. The couple live in a rented apartment and their monthly expenses, including the rent of Rs 20,000, are Rs 80,000. The two life insurance policies take away another Rs 8,250 from their monthly income pool on an average. The expenses grow once the monthly instalments of Rs 80,000 for two home loans are accounted for.

Agarwals have invested in two properties in Noida. One is a flat that is under construction, currently valued at Rs 85 lakh and with a balance of 17-year EMI outgo of Rs 47,000 per month. The other is a plot, presently worth Rs 55 lakh and a seven-year EMI outgo of Rs 33,000 per month.

“Both are very good investments,” explains Mohit. However, the huge EMI expense leaves negligible surplus for the couple’s long-term goals. The list only has indispensables, daughter’s education and her post graduation, son’s education and his post graduation, marriages of both the kids and the couple’s retirement. To realise these goals, Aggarwals need an investible surplus of Rs 60,604 every month and presently they manage to put aside only 9% of the requirement.

“These are fairly long-term goals. Besides, I and my wife have got salary hikes of 10% each this year. We are mainly interested in knowing how the increased income can be put to good use,” says Mohit. Come April, the couple’s investible surplus will improve by Rs 17,000 equating to Rs 22,750, which is much lower than the amount they need to achieve their goals. Also, with the responsibility of two kids and the liabilities Agarwals have, it is imperative that they keep aside a part of their surplus for emergencies. It is advisable that over the next couple of months, Agarwals build a contingency corpus equivalent to three months’ income.

Insufficient surplus is not the only issue. With such high exposure to real estate, Agarwals’ asset allocation is undiversified. The couple have zero investment in equities. Apart from the mandatory Employee Provident Fund, they have no debt cushion. The financial planning rule book strongly discourages such a portfolio. One should never keep all their eggs in one basket.

What if the Agarwals don’t get the kind of returns they are expecting? What if there is actually a real estate price bubble which bursts? The volatility in interest rates is further reducing the credibility of real estate as an investment. A survey by real estate website Makaan.com shows that 55% of potential home buyers expect residential property prices to fall by 20% or more in 2011.

It is seen that no single asset performs consistently for a long period of time. Diversified asset allocation is based on the notion that even as different assets move up and down, one gets consistent average returns in one’s portfolio. Also, real estate is a highly illiquid asset class and there are maintenance costs associated with it, which may be too difficult to handle. Hence, we suggest that Agarwals should sell their plot of land and use the amount to prepay the loan.

They should invest the remaining proceeds in diversified equity funds. Investments can take place over a period of six months through systematic investment plans (SIPs) to decrease the risk of volatility. Wealthcare Securities suggests directling all SIPs to HDFC Equity Fund , ICICI Prudential Dynamic Fund, Fidelity Equity Fund and Birla Sunlife Equity Fund . The loan liability, including the pre-payment charges, will be about Rs 22 lakh.

For the living standard that the Agarwals want to maintain after retirement, they will need Rs 6.56 crore. The couple’s Employee Provident Fund and insurance policies will be able to fund about 54% of the need. The remaining corpus can be built using two options. One, Agarwals can siphon off the entire balance of Rs 33 lakh from the property sale proceeds towards their retirement. This way, they will not have to make any further investments to secure their old age. The EMI can go towards improving their surplus further to Rs 55,750. The amount will be more than sufficient to achieve their other goals.

They can also look at another option, which will satisfy their desire to keep investing in real estate. They can keep Rs 10 lakh for retirement. In such a case, Agarwals will need to invest Rs 18,000 every month in diversified equity funds through SIPs. The balance of Rs 23 lakh can be used as down payment for buying a house of about Rs 80 lakh in about four to five years.

Assuming an annual growth of 12%, the investment will grow to about Rs 36 lakh in four years. By then, their incomes should also increase and they should be able to afford a 17-year home loan of Rs 40 lakh at the rate of 9% per annum. Also, in the next four to five years, Agarwals’ portfolio would achieve the much needed diversification. The couple understand the significance of saving in time for the education of their children.

Agarwals see an expense of Rs 10 lakh each for their daughter’s college and post- graduation. The fund needs pertaining to these goals are likely to arise in 13 and 16 years. Assuming an annual inflation of 7%, they will need Rs 24 lakh and Rs 29.5 lakh for these two goals. The couple will have to invest Rs 6,474 and Rs 5,128 in mutual funds through SIPs to build the corresponding sums.

For their son’s college and post-graduation too, Agarwals foresee a requirement of Rs 10 lakh each. To fulfil these targets in 14 and 17 years respectively, they will need Rs 25.8 lakh and Rs 31.6 lakh. Building these corresponding amounts will need a monthly investment of Rs 5,967 and Rs 4,776 in equity funds through SIPs.

Agarwals also want to stock an ample amount of money for their kids’ marriages. The couple expect their daughter’s marriage to cost Rs 25 lakh and in 22 years, they will need Rs 1.11 crore, to finance this expense. For their son’s marriage, they foresee an expense of Rs 10 lakh. The amount could escalate to Rs 50.7 lakh in 24 years. In order to generate these amounts, the couple need to start investing Rs 8,632 and Rs 3,062, respectively, on a monthly basis in equity funds through SIPs.

Agarwals have bought two Ulips to insure their lives. It is best if one keeps insurance and investments separate, but Agarwals have already borne the greater part of the cost associated with the two policies. Hence, it is not advisable for them to exit the policies. Hence, we have advised to utilise their benefits for building the retirement corpus. The couple need a lot more insurance than they believe they should.

Given their cash needs, the couple must have an insurance cover of at least Rs 70 lakh, but their present policies provide them with a cover of only Rs 38.7 lakh. Hence, we suggest that they buy a 25-year term plan of Rs 50 lakh. The annual premium for it should be around Rs 12,000.

Also, the couple should immediately buy a mortgage insurance cover equal to the home loans’ value. The coverage may be split between Mohit and Krittika according to their income ratio. Wealthcare Securities suggests covers offered by HDFC Life Insurance and Metlife for buying mortgage insurance.

Agarwals are responsible for two kids and, hence, having a health cover is essential. We suggest that they buy a family-floater cover of Rs 3-4 lakh and top it up with a Rs 2 lakh cover. Buying the top-up in Mohit’s name will be comparatively cost effective. The premium for the floater plan should be around Rs 6,000 per annum.

Agarwals can’t be praised enough for accumulating a generous amount of wealth but they have completely ignored the diversification of the risk element. It is high time they make amends. To increase the debt cushion, we suggest they open Public Provident Fund accounts in the name of all family members and invest regularly in these.

Source: Economic Times