Your savings should increase with time

A static, fixed investment amount won’t help you achieve your life goal

Most individuals set aside a fixed sum of money every month to achieve a life goal. In this article, we show why such fixed savings could expose you to the risk of goal failure.

We also show how to follow a savings process to improve your chances of achieving your life goals.

Fixed savings

Your typical savings process involves setting aside a fixed sum of money every month to meet a life goal, say, your child’s college education. This process is easy for you because there is certainty in your spending cash flows; you can consume the rest of your monthly income, assuming that you are not pursuing any other goal.

This process can expose you to the risk of goal failure. Why? The amount you save and the time horizon of your goal will decide your required return. Suppose you save ₹50,000 every month for the next 10 year and want to accumulate ₹1 crore — your required compounded annual return will be 4 per cent. If you, however, save only ₹30,000, the required return will be 9 per cent.

The point is that your asset allocation is a function of your required return. If your required return is higher than the post-tax return on bank deposits, you have to invest in equity. More the required return, greater should be your equity allocation.

Now, the issue arises because of your equity allocation. Picture this. You have 60 per cent allocation to equity and 40 per cent to bonds at the start of your investment process. Can you take risk with your investment as you get closer to your child’s college admission? What if the stock market tanks? All the effort you took in the previous years will be in vain because your investment portfolio will fall short of your required wealth to fund your child’s education.

That is why you have to adopt a glide path, especially if you are within five years of achieving your life goal.

A glide path is a process whereby you continually reduce your equity allocation in your portfolio and increase your bond allocation as you approach the end of the time horizon for your life goal.

Savings curve

So, adopting a glide path means you need to save more as you approach the end of the time horizon for the life goal. This is because the post-tax expected returns on bonds is significantly lower than that on equity. To make the process simple, it is best you increase your savings every year. That is easier said than done as increasing savings impacts your current consumption. So, what should you do?

You should step up your savings using your annual increase in salary. Suppose you expect to receive ₹15,000 per month as your salary increment and your typical savings rate is 20 per cent. You would already have ₹3,000 of additional savings this year (20 per cent of ₹15,000).

But you should actually increase your savings rate to 30 per cent of your incremental salary. So, you will have an additional savings of ₹4,500 instead of ₹3,000. The objective of using incremental salary is to increase savings without affecting your current consumption. Your additional savings each year will go toward bond allocation to reduce the investment risk in the portfolio.

There is another factor. Your savings is also a function of your goal priority. More important a goal, more conservative the investment portfolio should be. So, higher-priority goals will have higher bond allocation even at the start of the investment horizon for that life goal. And then as you apply the glide path, your savings will increase even more to further reduce the investment risk. The upshot is this: Fixed savings is not enough to achieve any life goal if you have risky (read, equity) investments in your investment portfolio.

The writer is the founder of Navera Consulting. Send your feedback to [email protected]

Published on August 11, 2019

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