Planning For Intermediate-Term Financial Goals

PPFAS Long Term Value Fund is advertised with a tagline: Only for "truly" long term investors!  The funds scheme document states, “Investors should note that this scheme is suitable for investors who have an investment horizon of minimum 5 years”.

Unfortunately,this can give investors the wrong notion that ‘long term’ implies duration of 5 years and that a diversified equity fund like PPFAS LTVF is suitable for a goal 5 years away.

Recently someone in the Jagoinvestor forum stated that they had invested in HDFC Prudence for a goal about 5 years away. His investment was in the ‘red’ after a couple of years and he wanted to know if her will able to generate enough returns in the remaining years to meet his goal.  The plain and simple answer is NO, unlikely.

Before we get to intermediate-term goals, let us ask a couple of questions.

How long is long term?

You will find many articles online that state there over a period of 15 years or so there is no chance of losing money in the stock market. So when it comes to equity investing, long term implies a period of 15 years. Although zero probability of money-loss is not that comforting after 15 years of investment, the result does make sense.

There is one other article which states long term is a minimum of 7 years, using probabilities of achieving certain target returns. I am not comfortable about this result as the odds of achieving low returns (even losing money) are still high enough (for me).

If we are dealing with an instrument that can be volatile, average returns make little sense without looking at the standard deviation – a measure of how individual values deviate from the mean. A standard deviation of 1% for an average return of 10%, implies that 68 times out of 100 an investor is likely to get a return between (10% - 1%) and (10% + 1%). That is within one standard deviation.

This definition haspractical use only when the standard deviation is much lower than the average! The average rolling return (CAGR) over a 7 year period is about 18%. The corresponding standard deviation is 11%. So 68% of the time returns can range from 7% to 29%. A huge variation!  Personally I am not comfortable about this because there is a 30% chance that returns will be lower than 7%

Over a 15 year period the average rolling return is about 16% with a standard deviation of 5%. The corresponding variation is much lower. However one should note that it still is significant volatility.

 Bottomline: As a crude thumb rule, I would like a standard deviation which is not more than half the value of the return (for example, a standard deviation of not more than 6% for a return of 12%). If we go by market history, this will happen only when the investment tenure is 10 years or more. More details about this analysis can be found here: Understanding the nature of stock market returns

How short isshort term?

This is a tougher question to answer! The first thing to do is recognise that the power of compounding is not significant for short durations. Here is another crude thumb rule. We knowshort term is going to be just a few years. So in this duration, we assume a moderate post-tax return of say about 5%.  If we invest Rs. 100 for 3 years, we will get a sum which is 16% more than our investment (~ Rs. 116). If we invest for 4 years, we will get a sum which is 22% more than our investment.

The percentage difference between the maturity value and the investment value (16% for 3 years and 22% for 4 years) will rapidly increase with higher investment durations. So I set the duration corresponding to an approximate percentage difference of ~15% as short-term. So about 3 years.

To summarise:

Short term: less than or equal to 3 years.

Long term: more than 10 years.

Intermediate-term: Between 3- 10 years.

Priorities associated with short-term and long-term goals are easy to understand (More details here: The Contended Investor)

Short-term:

  • Little or no fluctuations in returns to ensure no loss of capital.
  • Instruments: FDs, RDs, liquid mutual funds or even arbitrage mutual funds

Long-term:

  • Relatively large returns fluctuations necessary to get returns that can beat inflation.
  • Instruments: Significant equity exposure with adequate debt component. With diversification within each asset class.

These are extreme situations. Hence it is easy to choose financial instruments for investment. The risk appetite of the investor is irrelevant while planning for these goals. What matters is the risk profile of the goal

The trouble with intermediate terms goals is that there is no clear cut idea about how much volatility (fluctuation in returns) the goal can stomach. Do we invest only in fixed income instruments like FD/RD? Or do we choose an aggressive balanced fund (like HDFC prudence) in the hope of making good tax-free returns?

If we don’t care about tax outgo and think of tax as the price to pay for guaranteed returns, then FD/RD is a fantastic choice. I would recommend it for all short term goals and important intermediate term goals.

If an investor is driven by greed and wants post-tax double digit returns then the price he/she pays is not only volatilitybut also extended periods of poor returns. If our goal is 5 years away and if the invested fund gives negative returns for even two of those 5 years, we are likely to fall short of our net return requirement.

Image by Swen-Peter Ekkebus.
Image by Swen-Peter Ekkebus.

What we need to recognise is that volatility is a much bigger price to pay than taxes.

 We could consider (among other instruments) a debt oriented conservative funds like Reliance MIP for goals more than 3 years away.  However is it maybe surprising to note that its standard deviation is pretty high!

ReturnStandard deviation
3 years6.17%5.35%
5 years11.54%8.42%
Reliance MIP (source: Morning Star India)

This means that over a 5 year period return can be as high as 20% and as low as 3%! The cost of high returns is the possibility of pathetic returns!

Fixed maturity plans are a good bet for both intermediate and short term goals, provided we understand the nature of debt securities involved and associated risk.

Take the case of a debt fund like Templeton India Short-Term Income Growth. According to Morning Star, the average maturity period of its portfolio holding is about 2 years.

However, I would be cautious before using it for short term goals because its 3 year returns of 8.26% comes tagged with a standard deviation of 1.66%. So although volatility will be lower I must peg my return expectation carefully. For example one could expect a pre-tax return of 8.26% - 1.66% ~ 6%.  Anything higher than this is possible but with a much lower probability.

Also the danger of a bond crash cannot be discounted. An income fund may take several months to recover from a bond crash. So it would be risky to choose it for a short term goal. The risk is lower for an intermediate term goal. However the crash could occur toward the end of the investment tenure and lower returns significantly (my NPS tier I returns is a good example of this)

For a short term goal, I can blindly invest in a FD/RD/liquid fund and be done with it. For a long term goal, I will choose good equity mutual funds to start with, choose my debt options and slowly diversify over course a few months. That is for these type of goals it is easy to identify instruments that match the risk profile of the goal.

This is not so easy for intermediate-term goals. The investors risk appetite plays an important role. Trouble is most investors seem to think they can stomach higher risk without understanding the full implications of choosing an instrument.

In a waythis issue highlights the importance of starting early for crucial goals like retirement and children’s education. We cannot simply afford to let these become intermediate-term goals!

What do you think?

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28 thoughts on “Planning For Intermediate-Term Financial Goals

  1. bharat shah

    i found the post interesting and en-lighting , but frankly i am rather too complacent for understanding its details in total. simultaneously i read the observation of head of one of our mutual fund AMC that they see a good return for both, indian equity and debt , more for equity within 1-11/2 yrs. period , and found some substance in it. as i understand, you tried to make crude thumb rule between average return,standard deviation and volatility . if some made observations, he could have made the balance period to reach the top or so , and the next top, so for the current time , they can profess that the period is some 1-11/2 yrs from now.
    2. i feel , after all , this exercise is in essence 'timing ' the market. mind well, this is not the euphoria period of market, and still we have to think of definition of long period! is not better that we try to learn and find good businesses and invest in them for reasonably long , 5 yrs. or so period, and forget about the market movement?

    Reply
    1. pattu

      Thanks for your views. I am not clear about the point you are trying to make. I however do agree that investing in good business and holding onto them is essential for stock investors.

      Reply
      1. bharat shah

        i try to explain what i mean. instead of making thumb rule of holding period the investment irrespective of the particular time , can not we make the period reduced based on some period already lapsed? e.g. i invested five years before in equity mfs, which is still not performed well due to overall market conditions, but i can hope that it would performed well in coming 5 yrs (i.e. total10 yrs. holding period) and i would get return as targeted as per this post. so if, i add some more a/m in the same schemes now , but only for 5 yrs, and not 10 yrs and rightly hope to achieve the targeted return CAGR during the period. is it correct?

        Reply
        1. pattu

          I understand what you mean. You are saying breakup the total investment duration into smaller periods and evaluate returns. Yes that can be done. However if the first period is bad, there is no guarantee that the second period will be good!

          Reply
          1. bharat shah

            ' However if the first period is bad, there is no guarantee that the second period will be good!' there is no guarantee of my 5 years' old portfolio after completing 10 yrs either! but if we go by the thumb rule of 10 yrs.' holding, i can hope the same fate for my new investment now in the same fund (say index fund) as to older one. if that is true than one can advise for shorter period than 10 yrs. depending upon your when you start. am i correct?

          2. pattu

            I don't think it works that way. You invest with a known time frame and rebalance each year. Of course one should invest in asset classes which are not correlated with each for this. This is for period 10 years and above. Less than that, you are taking a chance with volatile instruments.

  2. bharat shah

    i found the post interesting and en-lighting , but frankly i am rather too complacent for understanding its details in total. simultaneously i read the observation of head of one of our mutual fund AMC that they see a good return for both, indian equity and debt , more for equity within 1-11/2 yrs. period , and found some substance in it. as i understand, you tried to make crude thumb rule between average return,standard deviation and volatility . if some made observations, he could have made the balance period to reach the top or so , and the next top, so for the current time , they can profess that the period is some 1-11/2 yrs from now.
    2. i feel , after all , this exercise is in essence 'timing ' the market. mind well, this is not the euphoria period of market, and still we have to think of definition of long period! is not better that we try to learn and find good businesses and invest in them for reasonably long , 5 yrs. or so period, and forget about the market movement?

    Reply
    1. pattu

      Thanks for your views. I am not clear about the point you are trying to make. I however do agree that investing in good business and holding onto them is essential for stock investors.

      Reply
      1. bharat shah

        i try to explain what i mean. instead of making thumb rule of holding period the investment irrespective of the particular time , can not we make the period reduced based on some period already lapsed? e.g. i invested five years before in equity mfs, which is still not performed well due to overall market conditions, but i can hope that it would performed well in coming 5 yrs (i.e. total10 yrs. holding period) and i would get return as targeted as per this post. so if, i add some more a/m in the same schemes now , but only for 5 yrs, and not 10 yrs and rightly hope to achieve the targeted return CAGR during the period. is it correct?

        Reply
        1. pattu

          I understand what you mean. You are saying breakup the total investment duration into smaller periods and evaluate returns. Yes that can be done. However if the first period is bad, there is no guarantee that the second period will be good!

          Reply
          1. bharat shah

            ' However if the first period is bad, there is no guarantee that the second period will be good!' there is no guarantee of my 5 years' old portfolio after completing 10 yrs either! but if we go by the thumb rule of 10 yrs.' holding, i can hope the same fate for my new investment now in the same fund (say index fund) as to older one. if that is true than one can advise for shorter period than 10 yrs. depending upon your when you start. am i correct?

          2. pattu

            I don't think it works that way. You invest with a known time frame and rebalance each year. Of course one should invest in asset classes which are not correlated with each for this. This is for period 10 years and above. Less than that, you are taking a chance with volatile instruments.

  3. Ramamurthy

    I am 84 with no pension.My only source of income is from investments.i have no liability and reside in a house which I own.
    My investments are in FD,Mutual fund,Direct investments in shares,NCD and Annuity schemes from LIC with NO money back option.The interest which I receive is sufficient to meet the expenses and also I can save.
    Contrary to the norrmal expert opinions I continue to invest in Equity shares.This investments made in Direct Equity during the last 3 Years ,to day has given me a return of about 32%.To day I may be lucky and may be in next 3 Years the investment may turn negative.I plan to rebalance my portfolio if the return falls to say 20%.
    What is your opinion on my strategy?What I am trying to say is that we must not place too much importance on period of holding,standard deviation etc. as long as you monitor the portfolio and take necessary corrective steps to churn your portfolio.Hope I have not offended you. I am a great admirer of your posts and very keenly look forward to read and benefit from your posts.

    Reply
    1. pattu

      It is fascinating to learn about the way you handle your finances. If you ask me, 32% is a fantastic return and you could afford to book profit and push some money into FDs.

      What you are saying makes perfect sense for long term goals. For intermediate term goals, one mistake will cost you quite a bit and course corrections may or may not work out.

      Thanks for your appreciation. I value your comments. If you have some suggestions on topics and calculators, do let me know. I will be happy to accommodate them asap.

      Reply
      1. bharat shah

        really overwhelmed to read about the fantastic return in period not so good for direct equity (and worse also for equity related mfs). you must have selected good businesses at very good price after researching on your own or through some adviser. better you enlighten in brief. as such, holding such businesses for long time is also not bad.

        Reply
  4. Ramamurthy

    I am 84 with no pension.My only source of income is from investments.i have no liability and reside in a house which I own.
    My investments are in FD,Mutual fund,Direct investments in shares,NCD and Annuity schemes from LIC with NO money back option.The interest which I receive is sufficient to meet the expenses and also I can save.
    Contrary to the norrmal expert opinions I continue to invest in Equity shares.This investments made in Direct Equity during the last 3 Years ,to day has given me a return of about 32%.To day I may be lucky and may be in next 3 Years the investment may turn negative.I plan to rebalance my portfolio if the return falls to say 20%.
    What is your opinion on my strategy?What I am trying to say is that we must not place too much importance on period of holding,standard deviation etc. as long as you monitor the portfolio and take necessary corrective steps to churn your portfolio.Hope I have not offended you. I am a great admirer of your posts and very keenly look forward to read and benefit from your posts.

    Reply
    1. pattu

      It is fascinating to learn about the way you handle your finances. If you ask me, 32% is a fantastic return and you could afford to book profit and push some money into FDs.

      What you are saying makes perfect sense for long term goals. For intermediate term goals, one mistake will cost you quite a bit and course corrections may or may not work out.

      Thanks for your appreciation. I value your comments. If you have some suggestions on topics and calculators, do let me know. I will be happy to accommodate them asap.

      Reply
      1. bharat shah

        really overwhelmed to read about the fantastic return in period not so good for direct equity (and worse also for equity related mfs). you must have selected good businesses at very good price after researching on your own or through some adviser. better you enlighten in brief. as such, holding such businesses for long time is also not bad.

        Reply
  5. abvblogger

    Nice post. Where are the rolling return data coming from? Also, I think average is good if one is planning to invest through SIP; if one is investing lump-sum, then it should be median return that is taken.

    Regarding Morningstar data, are they using rolling average returns?

    Reply
    1. pattu

      Hi, the rolling return data is from:
      http://freefincal.com/2013/07/18/understanding-volatility-of-investment-returns-with-a-portfolio-rebalancing-simulator/

      concepts like median, std and dev. and even average work only when the distribution is Normal. This approximation is valid only to a certain extent. Once the distribution is skewed I am not comfortable about using median.

      I dont think MorningStar uses rolling returns. I will be posting a rolling returns calculator next week.
      All returns are point to point, and these assume lump sum investments. Yes these averages cannot be used directly for SIPs but there are close enough representative of the funds performance.

      Reply
  6. abvblogger

    Nice post. Where are the rolling return data coming from? Also, I think average is good if one is planning to invest through SIP; if one is investing lump-sum, then it should be median return that is taken.

    Regarding Morningstar data, are they using rolling average returns?

    Reply
    1. pattu

      Hi, the rolling return data is from:
      http://freefincal.com/2013/07/18/understanding-volatility-of-investment-returns-with-a-portfolio-rebalancing-simulator/

      concepts like median, std and dev. and even average work only when the distribution is Normal. This approximation is valid only to a certain extent. Once the distribution is skewed I am not comfortable about using median.

      I dont think MorningStar uses rolling returns. I will be posting a rolling returns calculator next week.
      All returns are point to point, and these assume lump sum investments. Yes these averages cannot be used directly for SIPs but there are close enough representative of the funds performance.

      Reply

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