How to bridge investment value gaps

You should be willing to transfer money from your least- to high-priority goal

We have discussed about how you should create goal-based portfolios and reduce investment risk when you near the end of the time horizon for your life goal.

But what if, despite all your efforts, your portfolio falls short of the wealth you need to achieve your goal? In this article, we define investment value gap and discuss what you should do when you face such a gap.

Investment value-gap

Investment value gap (or value gap) is the difference between the amount you require to achieve your life goal and the actual amount you have in the portfolio. You should check if you have a value gap when you are five years from the end of the time horizon for your life goal. You have to apply a post-tax expected return of 10.8 per cent on your equity investments and the post-tax actual return on your bank deposits to determine if you can accumulate the required amount five years hence. This exercise will help you determine how to bridge the value gap in your portfolio.

We will focus on the value gap at the end of the time horizon for a goal. Suppose you need ₹1 crore to meet your child’s college education 10 years hence, but your education fund has only ₹75 lakh by 2029 — your value gap is ₹25 lakh.

Value gaps could lead to deep regret, especially if you are pursuing a high-priority goal. You could also suffer from hindsight bias. That is, looking back, you may wonder why you did not realise the risk of investing in equity or the need to save more to achieve the goal. We do not have a solution yet to moderate these emotions. You are human if you experience such emotions when you fail to achieve a life goal. But it is better to try and fail than not try at all.

What should you do when you face a value gap?

If you face a value gap in a high-priority goal (other than your retirement portfolio), you should adopt the hierarchy-constrained fungibility rule. You should be willing to transfer money from your least-priority goal to your high-priority goal, and not the other way.

Suppose you face a value gap in your child’s college education portfolio, you should transfer funds from your retirement portfolio to bridge the gap. On the other hand, suppose you face a value gap in the vacation portfolio that is not a high-priority goal, you should not transfer money from a portfolio earmarked for down payment for house if that goal ranks higher than the vacation goal.

What if the value gap relates to retirement goal? You could transfer money that you have set aside in the legacy portfolio (investments earmarked for your children after your lifetime). If you do not have a legacy portfolio, you should use your self-occupied house to raise money to bridge the value gap. That is, reverse-mortgage your house to supplement your post-retirement cash flows. The outstanding loan on the house will be adjusted against the eventual sale of the house after your lifetime or 20 years, which is earlier.

Suppose you fall short on your low-priority goal, you should either downsize your objective or abandon the goal if it can’t be achieved.

For example, you may decide to take a low-cost vacation if you have a value gap in your vacation portfolio. But suppose you want to buy a small beach house, you may have to abandon your goal if there is a value gap in the portfolio earmarked for the beach house. The money in a portfolio earmarked for a goal you have abandoned can be used for other higher-priority goals or for your retirement account.

The writer is founder of Navera Consulting. Send your feedback to portfolioideas@thehindu.co.in

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