Protective assets: A must for individuals

As part of our wealth-mapping process, we divide an investor's lifecycle requirements into three categories: protective assets, lifestyle assets and aspiration assets.

Of the three, protective assets are the most important. As the name suggests, these assets are created to protect an investor's minimum standard of living. The question is: How should investors map the products available in the market to their protective assets? The question assumes relevance because most investors do not separately create such assets.

This article discusses the need for protective assets and the reason such assets should be separated from lifestyle and aspiration assets. It then explains the required characteristics to map the products to such assets.

Why protective assets?

Investment is essential to enable individuals to meet their lifecycle objectives. This ranges from buying a house to creating a corpus to substitute active income during post-retirement life. Now, investment is built by channelising savings. And savings, in turn, is the excess of income over expenditure. It, therefore, logically follows that an individual's current income is essential to not only meet her current expenditure but also to build the investment portfolio required to meet future liabilities.

But what if the individual loses her current income? She may use her existing savings to meet current expenditure. And if savings are not enough, the obvious choice would be to withdraw money from the investment portfolio. But that would be sub-optimal. If the investment portfolio were created to meet, say, the child's higher education, depleting the portfolio would mean that the individual may be unable to send the child to the desired college.

Individuals would, hence, do well to set aside money to meet emergency requirements. Such requirements include medical emergency to meet costs in excess of the cover under medical insurance and temporary or permanent loss of income.

The objective is to ensure that the individual and her family enjoy the minimum desired standard of living despite the emergency requirement. We call these requirements collectively as protective assets within the framework of lifecycle investment.

Mapping protective assets

It is important to create and maintain protective assets outside of the investment portfolio because of their distinct characteristics. One, protective assets have zero risk tolerance. That is, the individual should not incur loss on investments mapped to protective assets. Two, the assets would be liquid because of the need to tap the resources at short notice, especially during medical emergency. And three, such assets should protect the individual's family from permanent loss of income.

We can map the appropriate products to the protective assets based on the above characteristics. First, individuals have to buy adequate life insurance to protect their family from permanent loss of income. The amount of insurance purchased should cover the repayment of loans outstanding and the household expenditure required to maintain the family's desired lifestyle.

Then, individuals need to set up a corpus to address temporary loss of income and medical emergency. An optimal capital should be not less than six times the current monthly expenditure for working people and 12 times the monthly expenditure for retirees.

The corpus can be kept in a savings account that is not operated for “normal” purposes. Individuals can take advantage of the sweep facility that banks offer on the savings account to enhance the cash returns. An alternative investment choice is liquid funds — money-market mutual funds that invest in T-bills and such short-term instruments.

Conclusion

We are often asked as to whether protective assets can be merged with lifestyle assets. That is, can individuals create a portfolio to buy a house six years hence but also use the same portfolio to meet emergency requirement if the need arises?

We believe that such a process may be sub-optimal because characteristics of protective assets are different from that of lifestyle assets. The latter can have equity and bonds in the portfolio. So, individuals cannot depend on such assets for emergency requirement, especially when asset prices have declined sharply. It is, hence, important for individuals to set up protective assets first before creating the investment portfolio.

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