An important part of your investment process is to ensure that your portfolio is accumulating the required amount during the investment horizon. In this article, we address two issues.

One, how you should determine whether your portfolio is short of the required amount during the investment horizon. And two, what you should do if there is a shortfall in the required amount.

Minimum return

Suppose you have 10 years before your child turns 18 and is ready to go to college. How should you set up an investment account today so that you have the money to pay for your child’s college education?

First, you have to estimate how much amount you require. You can take the current college fees and add 10 per cent a year for inflation to estimate the fees 10 years hence.

Next, you have to decide the lump-sum money you will deposit into that account.

Third, you also need to decide how much you are likely to contribute to that account every month from your current income.

Finally, based on your initial investment and your monthly contributions, you can compute the annual return required to reach the target amount 10 years hence.

You can use any savings calculator available for free on the Internet for this purpose.

Suppose you determine that your portfolio should earn a minimum return of 12 per cent each year for you to reach your investment objective.

Your portfolio could fail to achieve this return in any year because of the poor performance of your equity investments. This raises two questions: Should you check your portfolio’s progress every year?

And should you increase your equity investments in the hope that the stock market will perform well in the years ahead and make good the shortfall in your portfolio?

investment horizon

The answers to both these questions are based on your portfolio’s funded ratio at critical points during the investment horizon.

This is ratio of your current portfolio value divided by the target value at the end of the investment horizon.

Suppose you require Rs 60 lakh 10 years hence and your current portfolio value is Rs 30 lakh, your funded ratio is 50 per cent.

Your portfolio’s funded ratio should be typically 50-55 per cent at the end of 6 years, 75-77 per cent at the end of 8 years and 83-85 per cent at the end of 9 years.

You could broadly generalise this requirement to mean that your portfolio’s funded ratio should be 50-55 per cent when 60 per cent of the investment horizon is completed and so on.

Now, if you find your investment portfolio short of the typical funded ratio at the end of 6 years, you should not increase your equity investments in hope of bridging the shortfall. Why? You have only 4 years to unwind your portfolio and pay your child’s college fees; that gives you little time to recover losses should the stock market decline sharply during this period.

You should instead rebalance your investments so that you have at least 90 per cent of your portfolio in bonds (read bank fixed deposits).

These investments should be made such that they mature in the year your child enters college.

You should not risk your existing portfolio when it falls short of the funded ratio at critical points during the investment horizon. True, you will surely fall short of your target amount if you shift your equity investments into bonds, for bonds have lower expected return than equity.

You can instead increase your contributions to the investment account to bridge the gap, if such shortfall happens during your working years.

You can, however, consider increasing your equity investments to improve your funded ratio if the remaining investment period is more than 5 years.

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

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