Determining the lowest acceptable return

Savings is one part of the equation that places you on the path to achieving your life goal. Earning the required return through appropriate investments is the other part. In this article, we discuss how to arrive at a required return for a life goal and why you ought to increase your savings through the time horizon for a goal.

Asset allocation

You need to determine several factors to achieve your life goal. First is the time horizon for a life goal. Second is the amount that you require to achieve that goal. Third is the amount that you can save each month to achieve the goal. And fourth, the expected asset-class returns on equity and bonds.

You can determine the required return to achieve a goal using these factors. Referred to as the minimum acceptable return (MAR), it is the minimum post-tax compounded return per annum at which your investments must grow to accumulate the required amount at the end of the time horizon for a life goal. The MAR is important because it determines your asset allocation. This refers to the proportion that you ought to invest in equity and bonds to achieve a life goal. Suppose your MAR is 8.4%.

Based on an expected return of, say, 10.8% on equity and 4.05% on bonds, the asset allocation should be 65% equity and 35%. The proportion of equity and bonds in the portfolio should be such that the expected weighted average return of the portfolio equals the MAR.

Savings expansion

The MAR must be on a post-tax basis because the cash flow available to achieve your goal is after taxes.

The MAR will be constant through the time horizon for a life goal. The issue is that you cannot maintain the same asset allocation through a life goal.

Why? Recovering losses on your equity investments is more difficult than giving up gains. For instance, your investments must double to recover a 50% loss whereas a 33% decline in investments is enough to give up a 50% gain.

This means you cannot accumulate too much of unrealised gains in your portfolio earmarked for a life goal.

Also, you will have limited time to recover losses on your equity investments should a market crash occur closer to your goal deadline.

For these reasons, you should have a higher allocation for bonds when you are closer to the end of the time horizon for a life goal. Suppose you are pursuing a 10-year life goal and start with a 65/35 allocation to equity and bonds. From the sixth year, you should gradually cut your equity allocation and move towards bonds.

But this process will reduce the expected weighted average return on your portfolio, for, the expected returns on bonds are lower than that of equity.

So, the only way you can maintain your MAR and accumulate the target amount is to increase your savings. Increasing savings is easier said than done. After all, savings is a function of your current lifestyle requirement and your income.

Savings from salary raises

Fortunately, you can increase your savings without cutting your current consumption. How? Every year, your employer is likely to give you a salary raise. You can save a significant part of that raise (in addition to regular savings) to make-up for the decline in expected return on your portfolio. The proportion of equity in your portfolio is a function of two variables — the time horizon for a life goal and the importance of the goal.

Typically, the longer the time horizon, greater the ability to take risk. But the more important a goal is for your family’s well-being, the lesser your ability to take risk. You should incorporate these factors into the asset allocation decision when pursuing your life goals.

(The writer offers training programmes for individuals to manage their personal investments)