Please mind the gap!

Periodically check and manage your financials to avoid investment-value gap

Picture this. You have been investing for eight years. Two years hence, your child is scheduled to enter college. You are worried whether you will have enough money to fund her education. If it is not your child’s education, it is, perhaps, another life goal that you are worried about. There are numerous reasons why we may fail to achieve a life goal. In this article, we discuss several such reasons. We also show how you can reduce the risk of failure.

Investment-value gap

Investment-value gap is the difference between the target value you require at the end of the time horizon to achieve a life goal and the actual amount you have accumulated in the portfolio. Suppose you require ₹1 crore to fund your child’s education 10 years hence, but you have accumulated only ₹85 lakh; the investment-value gap is ₹15 lakh.

You could face investment-value gap for several reasons. First, the portfolio’s actual return could be lower than the required return (Minimum Acceptable Return). Suppose the portfolio’s MAR is 9 per cent. That is, your portfolio has to earn a compounded annual return of 9 per cent to accumulate the desired value at the end of the time horizon. But the actual return is only 8.25 per cent.

Second, actual inflation is higher than assumed inflation. Suppose you want to buy a four-bedroom house five years from now. Assume that the current cost of a similar house is ₹3 crore. If you assume the annual housing inflation would be 10 per cent, your dream house should cost ₹4.83 crore five years hence. So you need to accumulate ₹97 lakh if you intend to make a down payment of 20 per cent. But what if the actual inflation turns out to be, say, 12 per cent?

Third, you will typically save less during the initial years and increase your savings as you approach the target date. Suppose your child’s education fund has a time horizon of 10 years and you need to save ₹30,000 every month to reach the target value. You are more likely to initially save ₹20,000 and gradually increase the amount over the years to achieve your target value. Why? For one, you may have other goals to pursue during the initial years. For another, you can increase your savings each year as your income rises. Also, your desire to achieve a goal intensifies as you approach the target date. But what if you are unable to increase your savings as required?

Gap management

An investment-value gap does not mean that you will fail to achieve a life goal. It simply means that you have to engage in gap management. But you need not always wait till the end of the time horizon to take action. You should review the portfolio for possible gap management at least two years before the target date. Assume that your target value is ₹1 crore and MAR is 9 per cent. So at the end of the eighth year, you should have ₹84 lakh in your portfolio. Over the next two years, this will accumulate to ₹1 crore at a compounded annual rate of 9 per cent. So an amount less than ₹84 lakh requires gap management.

You can fill the investment-value gap in one or more of the following ways: One, you can increase your savings. Two, you can transfer money from an investment account earmarked for a lower-priority goal. For example, you could transfer money from your retirement account to your child’s education account to fill the gap. And third, you can borrow money. This should be your last resort, and can be done at the end of the time horizon.

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

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