Ajay starts investing Rs. 5,000 per month towards his child’s education. He has been advised that if he makes 10% year on year, in 20 years he will reach the target of approximately Rs. 50 lakh. Now suppose in a particular year, his mutual fund gives a 21% return, but Ajay’s friend mutual fund gives 34% return. This will definitely make him think that his fund performed poorly compared to that his friend. But he would recognize that he is still on his path and has outperformed his own benchmarks. He has made better progress than expected. In the next year, if his fund gives a 5% return and his friend’s mutual fund gives a negative 10% return, he might be a bit relaxed and happy about the fact that at least his mutual funds performed better than him. But the next moment he will come back to his own financial life and feel that whatever the case, he has underperformed his target of 10% each year which could not be able achieve the target of Rs 50 lakh for his child’s education.
In both cases, it will be about YOU and YOUR GOALS first and only then will you see it in perspective. If you don’t have any goals and targets, the only benchmark you have is comparison with others. Then you start looking at your friend’s return, the best funds in India and the average in the category in which you have started. So, let’s first start with setting your financial goals.
What are your Goals?
Do all of us have some financial goals? Yes, we all do. These may include buying a nice house, second house, car or big car, going on vacation or world tour, getting a better regular income, funding your children’s education, a retirement free from money-related worries, etc. What do you think would happen if someone comes to you and tells you that all your financial goals in life will be met with a 100% guarantee, irrespective of how much you earn, no matter what happens. Once you are clear about your goals, you start investing towards them and get set rate of return on your investment and you realize that your financial life is unique; you stop comparing it with that of others.
Setting of returns involves careful study of few factors:
- What is the present value of my goal?
- What is the time-horizon of my goal?
- What will be inflation factor over the years?
- What should be the periodic investment towards the goal?
- What product mix we have to take?
- What risk is involved in return?
Aftermath, then do you think you would still carry on with your investments? Would you still worry about buying the best mutual fund and not the 3rd best one? Would you still shift your investment to a new financial product for the extra 1%-1.5% p.a. return?
No, you wouldn’t. I am sure that you would then concentrate on how to achieve your goals faster rather than on how much returns, product names, fancy strategies… You would start thinking at a different level and that would result in a simple financial life! Your only concern would be how to achieve your financial goals fast and as easily as possible.
Real rate of Return
Now, we have to ascertain what rate of return is required to achieve my financial goals. Are we using the right word “rate of return” to reach our target amount? Surely not! Rate of return means we are talking about just nominal return as we don’t consider the effect of inflation. For example the 8% earned in a bank fixed deposit is nominal return. But this is not the correct way of measuring return. The return calculated after considering the effect of inflation and taxes is the right way to measure the return and is known as the real return or may be called so as post tax inflation adjusted return.
Let’s understand “Real rate of return”, assuming your investment has made return of 8% (nominal return) and the average inflation that year was 10%, the real return is a negative 1.81%. Which means actually on maturity you did not make any money; in fact your money has lost value due to inflation. Inflation is a silent monster and it erodes the value of your money if you don’t invest above the inflation rate. So consider the effect of inflation while measuring your returns on maturity.
Ask yourself what is the fundamental requirement – getting high returns now or making investments for your life & goals ahead. The sole objective or goal in life cannot be just making lots of money; it should actually be meeting one’s goals on time.
If that is the case, the right question to ask yourself is “What is my required real rate of return & where do I invest, which will help me achieve my financial goals easily and comfortably?”
While all that is fine and required, to some extent, the only point I want to make is that after setting goals and linking your investment to them, your financial life becomes simpler and you have fewer things to worry about than getting higher return. Always look at the performance over the long-term and conjunction with your goals.
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