Sometimes, you receive unexpected cash flows. These can be in the form of a surprise bonus from your employer, a share of a disputed ancestral property, a gift from your aunt or winning a bet. The question is: How should we use such cash?

This question is important because you may be tempted to utilise the unexpected cash flow in ways that you may regret later. Here are five ways you can use your discretionary cash.

Suggested utilisation

For the purpose of this discussion, we define discretionary cash to mean money that you have in addition to your regular income from which you save and invest to achieve your life goals. The following are some of the ways you can utilise your discretionary cash.

You should increase the size of your emergency fund. This fund is created to meet medical emergencies or even pay for your monthly living expenses in the event of temporary loss of income. Your preferred choice should be to deposit your discretionary cash in your emergency fund if the fund’s corpus is less than six times your monthly living expenses, including your home-loan payment.

If you have enough money in your emergency fund, you can use the discretionary cash to prepay loans that you have availed of to buy depreciating assets, such as a car or high-end consumer durables.

Why not prepay your home loan? For one, your discretionary cash may not be large enough for the prepayment to have a significant difference on your interest payment. For another, depreciating assets lose value faster than even old apartments. Avoid the pain of having to see your depreciated asset value being lower than your loan value!

Side-pocket account

You can consider setting up a side-pocket account. This account will use the discretionary cash to invest in bank fixed deposits with maturity of one year or less.

You can liquidate these bank deposits and invest the money in shares to bridge any shortfall in your equity portfolio in a year when the stock market declines sharply. Note that if you choose to prepay your existing loan as mentioned above, the amount you would have otherwise used every month to repay your loan can now be used to fund the side-pocket account.

You can choose to buy gold if your current investment in gold is less than 15 per cent of your total portfolio value. Your purchase of gold can be regardless of the price levels. This is because gold is typically a consumption asset. That is, you are buying financial gold to convert it at a later date into physical gold for personal consumption and not to generate gains as is the case with stocks.

Finally, you can invest in passion assets. These are investments that you make in assets that form part of your collectibles such as antiques, coins and paintings. Your investments in passion assets should not exceed 10 per cent of your total portfolio value, as such investments are illiquid.

You may be tempted to use the discretionary cash flow to invest in high-risk assets, for instance, alternative investments such as farm land. Of course, you could spend the unexpected cash on products that you would not otherwise buy with your “regular” cash flow. The discussion here will apply only if you want to invest your discretionary cash and not if you want to consume it on luxury products.

Our suggestions are aimed at helping you improve your protective assets (increasing your emergency cash), pay down your loans or increase the size of your satellite investment (within the core-satellite framework) without substantially increasing your portfolio risk.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. Feedback may be sent to knowledge@thehindu.co.in)

Related Topics