Investment Options for Short-term Financial Goals

Published: April 16, 2015 at 2:43 pm

Here is a list of investment options available for goals which are less than or equal to 5 years away. This is sourced out of my response to a thread at Facebook group, Asan Ideas for Wealth.

I think the first step in goal-based investing is to demarcate short-term, intermediate-term and long-term financial goals. For me,

Short-term goal </= 5 years

Intermediate-term goal 5-10 years

Long-term goal 10+ years.

This is in part based on the standard deviation observed for equity for different investment durations. For me,

No equity for less than 5 Years, unless the goals is a flexible ‘want’.

Not more than 20-30% equity for intermediate-term goals

Not more than 60% equity for long-term goals.

Let us now look at short-term goals in detail.

There are two kinds of short-term goals

  1. Recurring (every few months, every year etc.)
  2. Non-recurring.

Recurring goals

Recurring could be anything from a life insurance premium, school fees or a holiday every other year. You can use this recurring goal calculator to plan ahead for such goals.

Recurring deposits are the most natural way to save for such goals.

If one wishes to do away the process of opening and closing RDs, then liquid funds will do the job efficiently. You keep putting some money away for your recurring goals and redeem when you want.  The only disadvantage here is that you don’t know how much to invest each month.

In a recurring deposit, the compounding is quarterly and you have a clear idea of how much you will get post-tax. So you can deposit a sum accordingly. This is not possible with liquid funds. You may have to assume a 6% annual return and invest a little more than necessary, just to be sure.

There is no free lunch. Convenience comes at a cost!

Now that RDs can be opened and closed online, I like them better than liquid funds. Of course one needs to keep track of them and ensure the savings account has enough money on the  RD.

Investor also have the option of investing variable amounts in RDs but I have not found the need for such instruments.

Instead of a recurring deposit, if one can afford to invest a lump sum for such recurring goals, arbitrage funds or equity savings funds (which invest in arbitrage +short-term bonds) can be used to get tax-free gains after 365 days, as per current tax laws. As long as return expectations are small (~ 6%), these should do fine.

SIPs in such funds can be messy from a tax point of view. Most of the units will be less than a year old (for annual goals) and will attract tax at 15%. This is still better than RDs or liquid funds for those in 20% and 30% slabs.

However, it is important to recognize that arbitrage and equity savings funds comes with non-zero risks and result in negative returns over the short-term. So do not use such funds for just a few months.

Non-recurring short-term goals

When the investment duration is short, there is no difference between risk and volatility. Volatility in an instrument has a pretty good chance of resulting in loss of capital as there is little time to recover. So it is important to tread carefully.

Low risk options

  1. Fixed deposits and Recurring deposits from recognized banks. However, TDS and yearly declarations of gains as income will affect compounding. Best suited for less than or equal to 3Y durations.
  • Liquid funds, ultra-short term funds, low duration income funds. These are funds with an average portfolio maturity of less than 1 year or so. Sensitivity to interest rate movement is typically small, credit risk is also small, provided the fund does not invest in low rated bonds – must look at the folio for this. Best suited for durations above 3Y.

Note: while investing via SIP, only units greater than 1095 days (3Y) will be taxed at 20% with indexation. Younger units will be taxed per slab. You can use this Mutual Fund Capital Gains calculator to figure out age of units and tax liability

  1. Arbitrage funds can be used for durations above 1Y. I will not expect more than 6-7% from these. Read more: How Arbitrage Mutual Funds Work: A simple introduction

Moderate risk options

  1. Debt-oriented balanced funds which invest anywhere between 0-25% in equity may be used for 5Y+ durations. It is difficult to estimate returns over 5Y periods and there is a definite risk of capital loss. Over 7Y+, I will expect about 9% from such funds before taxes.  Not recommend for important short-term goals.
  2. Equity Savings funds: They are a mix of arbitrage, direct equity (about 0-255) and fixed income.  Read more: How & when to choose Equity Savings Funds & Arbitrage Funds

High risk options

  1. Equity-oriented balanced funds which invest about 65-75% in equity is an extremely high-risk option with a certain risk of capital loss. If I have an expensive ‘want’, say a sports car in mind, I might take a chance for short durations with such funds. A definite no-no for important goals!

Obviously the same goes for pure equity funds or direct equity as well.

This is as far as my thinking takes me. Let me know if I have missed anything.

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