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| Capitalstars Investment Advisor |
The recent volatility in the stock market, triggered by global and domestic factors, has made investors jittery. It has also highlighted the fact that the market mood can change rapidly and torpedo your critical financial goals if you are not protected adequately.
The recent correction, however, has reiterated the danger that the changing market moods can pose to your goals. This is because goals are planned on the basis of certain assumptions, and if these go wrong, the final outcome can be very different from what you were expecting. If the actual returns from the investment are far lower than the projected returns, your goal will be in jeopardy because your accumulated corpus will fall short of your requirement. For instance, if you invest Rs 10 lakh in an equity mutual fund, assuming a CAGR of 15%, you will expect Rs 40 lakh in 10 years. However, if the CAGR turns out to be just 10%, you will amass only Rs 26 lakh at the end of 10 years.
Why do you need a cushion?
Though you need to assume correct inflation and return figures while planning your goals, you have no control over the final outcome because no one can predict how the markets will perform. There is no guarantee the markets won’t tank as you are nearing your critical goals. Hence, building an adequate buffer is the best way to protect your goals from the market vagaries. By doing so, you can avoid the need to divert funds from one goal, say, retirement planning, to meet another goal, like a child’s education.
How much do you require?
The next step is to determine how big a cushion you need. “Calculate the cushion for each goal. As a thumb rule, a cushion of 15-20% of the future goal value is enough,” says Amol Joshi, Founder, PlanRupee Investment Services.
How to calculate the buffer amount
There are several rules that define the manner in which you calculate the size of your cushion.
Importance of goal: The first rule is simple and based on common sense. The more critical your goal, the higher the buffer you create for it. So, crucial goals like a child’s education should have a higher cushion, while low priority goals like travel can do with a lesser amount.
Time horizon: The second rule takes into account the goal’s time horizon. “You need a small amount for a goal with a flexible deadline or where the money is needed over a longer time frame, such as retirement. You need a bigger buffer where the deadline can’t be extended, say, for the higher education of your child,” says Harsh Roongta, a Sebi-registered investment adviser.
Nature of withdrawal: How you draw down the corpus defines the third rule of cushion creation. The buffer will depend on whether you want the entire money at one go or in installments over several years. A goal like your child’s marriage means that you will need the money at one go and, hence, a higher cushion is imperative.
Asset class: The final rule is decided by the asset class you choose for investment. Most people recommend the equity route for long-duration goals because the expected returns are higher. However, volatility is also high. In other words, you need more cushion if you are trying to achieve goals through volatile asset classes like equities. “If one has the liberty to achieve one’s goals using the safer debt option, there is no need to have a big cushion,” says Melvin Joseph.