Why IS Budgeting Important?

By: Ankitha Jain

If we had a penny for every time someone said, “I haven’t started investing because I don’t earn enough,” we would be crorepatis by now. People who say this are missing the entire point of investment- with a little bit of discipline, no income is small enough to not invest.

Many of us dream of becoming wealthy but are not sure about how and where to start from. We think that with our current salary this would be next-to-impossible, but it is not.

All that is needed is discipline in our saving and investment habits, and wealth will get accumulated over time. The journey towards financial freedom starts by budgeting for a clear roadmap.

Creating a budget can simply help in balancing expenses with income. Each time we earn money, track it as income and each time we spend money track it as an expense. It allows us to determine in advance whether we will have enough money to do things we need to do or would like to do. Even after we get the budget established, we will need to revisit it periodically with major life changes.

Let’s look at how simple a budgeting exercise can be. We start by writing it at the beginning of the month and reconcile it at the end of the month. The variance warrants deeper analysis, depending on our individual (personal and professional) situation.    

sample budget
Source: Tavaga Research

There is another way to think about budgeting for the long term.

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The approach to building wealth could be tailored to the different stages in our lives and not remain constant throughout. Strategies need to accommodate the changes that come with transition. The financial markets fluctuate, and our financial needs change over time. Similarly, income levels, spending patterns, and family situations alter.

Here is how a financial life-cycle could be simplified:-

Source: Tavaga Research

If we want to become wealthy, we tend to follow “Income-Savings=Expenses”. As suggested in Robert Kiyosaki’s book Rich Dad Poor Dad, “spend only the amount available post savings and investments – Pay yourself first!

Here is an easy way of paying yourself first:- 

Source: Tavaga Research

Once we get our budgeting right, the next question will be “where to invest?”. Amidst the high-decibel noise around financial products, this can be quite a task, especially for a beginner. Let us take a closer look at some popular financial instruments.  

FINANCIAL INSTRUMENTS:

Bank Fixed Deposits:

Bank fixed deposits offer a safe source of income as they give a fixed rate of interest for a fixed tenure. The tenure can be as short as seven days or as long as 10 years. Each depositor in a bank is insured for up to a maximum of Rs 1 lakh for both principal and interest amount. 

The interest earned on a bank FD is subject to tax as per our income tax slab. The amount of interest income we get is added to the ‘Income from other sources’ and then taxed. Illustratively, on a bank fixed deposit of 7.5 percent per annum, the after-tax return for taxpayers in the 5 percent, 20 percent and 30 percent tax brackets works out to be 7 percent, 5.94 percent and 5.16 percent, respectively

Exchange Traded Fund (ETF):

Exchange traded funds or ETFs are passively-managed instruments and are a good match for retail investors (they do not need us to have an expertise in the equity market), looking to grow their wealth over longer periods of time. ETFs are diversified in nature and are easy to track (since they are linked to an index). For example, a Nifty50 ETF will have an underlying portfolio that is identical to the Nifty50 index. ETFs are primarily bought to get benchmark market returns. 

ETFs are growing to make more sense, especially in India where the market returns (Nifty50) have averaged around 13 percent a year (annual compounding) over the last 15 years. These are low-cost funds which follow the index of an equity or a commodity market. There are no entry and exit costs, unlike in mutual funds.

Diversifying with an ETF creates an opportunity to illustrate the benefits of passive investing to a beginner. ETFs have lower fund management fees than most mutual funds. MF expenses are 1-2 percent. ETFs have no trailing commission for distributors as they are traded on the exchange, unlike mutual funds.

Gold:

Considered as a safe haven, gold stands us in good stead especially in highly volatile times. Given the current economic indicators, we might need a more dependable commodity such as gold to be part of our portfolio, along with other market-driven instruments. 
Gold’s price is governed by international macroeconomics, including the movement of currency (USD vs INR).  Traditionally, people have been investing in jewellery or in coins and bars, but today we can invest in gold in other ways. Paper gold, such as gold ETFs have no entry costs. They don’t come with storage and safety hassles and offer good liquidity to the investors.

Public Provident Fund (PPF):

PPF is one of the most popular savings vehicles in India. PPF comes with a lock-in period of 15 years.  Anywhere between the minimum contribution of Rs 500 and a maximum of Rs 1.5 lakh is allowed each year. We can either invest a lump sum or through monthly contributions. Only an Indian resident can open a PPF account. We must remember joint ownership is not allowed. Even though PPF has a lock-in period of 15 years, it offers partial liquidity through loans and partial withdrawals. After maturity, the subscriber has the option to extend the maturity period of the account in blocks of five years. 

National Pension Scheme (NPS):

Under NPS you can contribute regularly in a pension account during your working life. Upon retirement, you can withdraw a part of the corpus as a lump sum and use the remaining corpus to buy an annuity for financial security. NPS offers two accounts: Tier-I and Tier-II. Tier-I is a mandatory account and Tier-II is voluntary. The big difference between the two is in the withdrawal of money invested in them. We cannot withdraw all the money from a Tier-I account until retirement. Even upon retirement, there are restrictions on withdrawal in the Tier-I account. You are free to withdraw the entire money from the Tier-II account. We have to contribute a minimum of Rs 6,000 in the Tier-I account in a financial year. We can claim a tax benefit deduction of up to Rs 50,000 under Section 80CCD (1B), in addition to the Rs 1.5 lakh, permitted under Section 80C.

Insurance:

Not to be confused with an investment option, but the right insurance cover can protect the things that matter to us, including our family’s financial future. If we are the sole bread earner, we must get a term insurance. Term plans are pure insurance products that are the cheapest and the best way to buy a large insurance cover. However, you don’t get any money back from term plans at the end of the term or up on maturity

With the term-life insurance option, there would be no financial burden in our absence and our family could carry on with their lifestyle. Unlike any other life insurance product, we can buy a term insurance plan without shelling out too much. For example, a risk cover of Rs 50 lakh for a man of 25 years of age could come for as low as Rs 4,184 annually, i.e. less than Rs 12 a day. If we buy term life insurance early, the monthly premium is less. The thumb rule says we should buy a term insurance cover which is 10 times our annual income. So, for an income of Rs 10 lakh a year, the term insurance should be for around Rs 1crore.
We talk about why insurance is not an investment product here

Non-Convertible Debenture (NCD):

Whenever a company wants to raise debt money from the public, it can use many routes. One such option that has gained prominence is NCD. These offer a high rate of interest to investors when compared to fixed deposits. While most banks are offering around 7 percent a year, over three- to 10 year-periods, NCDs offer around 9 – 10 percent over the same tenure. The interest earned during the year is to our total income, and hence, it is entirely taxable as per our income tax slab. Both bank FD and NCDs suit those in the lower tax brackets. If we need to allocate funds to the fixed-income portion of our portfolio, and we are looking for an alternative to a bank FD, we should consider an NCD. However, we would need to look at the ratings of the NCD and invest only in those that have a high rating, indicating a low credit risk.

Asset Diversification:

Asset diversification means investing our money in different ways to benefit from the balancing effect (if one of our investments is losing money, another one making money can balance the effect). It basically has the underlying principle of “don’t put all your eggs in one basket”. Read more about its benefits here.

If we understand the market, we can invest in the stock market directly. We can start by buying different stocks every month and diversify our portfolio to make sure no single stock or sector has too much weightage. Thus, it would help us stabilise our returns over the years, and easily rebalance any sector or stock which is having a bad run, weighing down our portfolio.

But what if someone is unsure of  how to invest in the stock market? 

Instruments like ETFs (Exchange Traded Funds) will come to the rescue. ETFs are quasi-equity stocks that track the market index (a Nifty50 ETF will track the Nifty 50 market returns; as seen in the example above, if we had invested Rs 1,000 in the ETF, we would have received a 543 percent appreciation in 15 years). They have a lower expense ratio than mutual funds, no commissions and are traded on the stock exchange. They provide asset diversification, allowing spreading of risk.

Here we list some of the better ways to invest

While making any investment, we should look at the characteristics of the investment including returns, risk, liquidity and tax efficiency.

Source: Tavaga Research

Before looking at the above investment avenues, we should be clear of our risk profile and the tenure of our investments. Here are 11 a few more things to know before investing.

It is not necessary that a 20-year-old will hold all their investments till the age of 60, or a 50-year-old investor will take out all their savings on turning 60.  

When planning and budgeting, one of the most important steps to take would be to map the cash flows objectively. We should objectively identify the goals that we are looking to fulfil in the future. That is what will help us to create an asset allocation around our financial goals, which you can read more about here.

When we choose our investments at various stages in life, they have to make for a robust and diversified portfolio. 

Risk being another guiding principle, we can say the more the risk-taking ability, the more the exposure towards equity instruments. Let us take a person aged 25 years,  and looking to invest for the next 20 years, with a moderate risk-taking ability.

On the basis of this, her portfolio could look like this: 

Source: Tavaga Research


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