How to choose the right financial product

How to choose the right financial product suitable for my needs?” How I wish this question was asked more often! Instead, many investors (if not most), soon after they start earning, ask questions like, which is the best tax-saving product?, the best pension plan?, the child plan?, best mutual fund ? etc.

The right answer to the wrong question does not help much. An attempt to answer the titular question by focussing on personal needs –> deciding an investment strategy –> choosing a suitable class of products and then (only then) —> choosing the right financial product.

This post is meant for young earners. Request experienced readers to please share this post with their contacts.

Some self-explanatory questions:

  • How much can I set aside for investment/saving each month?

A simple cash flow analysis: how much is earned, how much spent and how much is left, is enough to tell you this.

  • How much of this amount am I going to ‘save’ for short-term goals (less than 5 years away)?

The benchmark for such goals is capital protection. That is, I will not use volatile instruments for such goals. This eliminates stocks, equity mutual funds, gold, ULIPS, all debt mutual funds except liquid and ultra-short-term funds.

Simple products like fixed deposits and recurring deposits will get the job done (tax liability and inflation can be ignored for short-term goals) for durations below 3 years.

One does not need a portfolio for such goals. A single financial product is enough.

If the return is fixed and guaranteed, liquidity is not an issue. The money can be locked in.

  • How much of this amount am I going to ‘invest’ for long-term goals (more than 10 years away)?*

Inflation is the primary benchmark for such goals. Reducing tax liability is the secondary benchmark.

Such goals require a portfolio. That is. it must contain a basket of different financial products.

Some of it volatile, but with high potential to beat inflation – stocks or equity mutual funds. The fact that gains from equity instruments are currently tax-free is an icing on the cake.

Some of it steady – they may not beat inflation, but lend crucial stability to the portfolio:  fixed income products like debt mutual funds are preferable to fixed deposits because of lower tax liability.

Once we understand that both types of products are crucial for the goal, the next step is to decide on the asset allocation for a financial goalThat is, the percentage exposure to equity and fixed income should be decided. Say, for example, 50% in equity and 50% in fixed income.

Tax-saving options are available in both categories: Equity Linked Saving Scheme  (volatile ) mutual funds with a lock-in of 3 years and PPF (steady income) with a lock-in of 15 years.

The amount set aside for long-term goals can also include the amount to be used for tax-savings.  For example, if two lakhs a year is to be allocated for long-term investments, 1.5L of that can be set aside for tax savings: 50% in ELSS mutual funds and 50% in PPF (that is in the same proportion as the asset allocation).

Key takeaway: Financial product categories are decided as per when the corpus is required. Choosing the right product category is the major step. Once there is clarity about this, it is so much easier to choose the product from that category. One product from that category can be a tax-saving product. There are several posts here on choosing equity and debt mutual funds. You can check them out using the search option.

Liquidity of a financial instrument is a key factor. An asset is an asset only if it can be liquidated at will.

Real estate is a big no-no because of this reason.

NPS is a bigger no-no because of this reason: Do Not Invest Rs. 50,000 in NPS For Saving Tax!

Anything that is difficult to liquidate at the time of need or in case of emergencies (emergency fund can help only so much sometimes).

All products discussed above are extremely liquid under normal circumstances (please don’t quote the JP Morgan case here, please!)

(*) Planning for goals between 5-10 years can be a bit tricky. You could consult this post for some thoughts: Planning for intermediate-term financial goals

In summary, to choose the right financial product,

Understand the need  –>  write down an investment strategy –> Shortlist product categories that fit in this strategy  –> Choose products from that category, including tax-saving products, inline with the investment strategy.

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