Any financial planner worth his salt will vouch for the importance of diversification while building a portfolio. Furthermore, the diversification needs to work at various levels.
For example, within each asset class, it is pertinent to be invested across multiple instruments; similarly, the portfolio should be diversified across various asset classes as well.
Our team of financial planners recently met a client whose portfolio was anything but diversified. And this wasn't his only problem. To make matters worse, he seemed to have contravened every basic tenet of financial planning, making his portfolio an ideal candidate for a makeover.
The facts of the case:
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The client is 40 years of age, and the sole earning member in his family.
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His wife is a homemaker and his sons are aged 10 and 5, respectively.
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He is employed with a multinational corporation and his salary income more than makes up for his expenses, i.e. the monthly cash inflows outweigh outflows.
The client's investments/financials are as follows:
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He has invested in 3 properties (including the one in which he resides), which account for 83% of his assets.
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Equities (stocks and investments in only 2 diversified equity funds) account for 16% of assets.
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The balance (1%) is held in cash/savings bank accounts.
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He has opted for 2 children's ULIPs (unit linked insurance plans), the total annual premium for which is Rs 120,000.
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On the liabilities front, he has an outstanding home loan and also a loan against his mutual fund investment.
As can be seen, property, i.e. real estate, as an asset class accounts for a disproportionately high portion of the asset portfolio. Furthermore, all the properties are in the same city, depriving the client of any diversification opportunity. While it is important to have property in one's portfolio, it certainly shouldn't account for such a high proportion.
Also given that property as an asset class tends to be rather illiquid (a distress sale when liquidity needs are urgent could lead to a loss-making proposition), only accentuates the unenviable situation. A downturn in property prices could spell disaster for the client.
The remedy for this situation lies in introducing other assets like equities into the portfolio and thereby converting the portfolio into a more balanced one. Studies have shown that equities as an asset class (if invested smartly) can outperform others like real estate, gold and fixed income instruments over longer time frames.
Considering that the client's needs (planning for retirement and providing for children's education) are long-term in nature, the presence of a higher equity component should be treated as vital.
The solution -- put on hold any plans to buy more property. At Personalfn, we maintain that each individual should be invested in property to the extent that it can provide for inheritance. With 3 properties, the client has adequately taken care of that.
The surplus cash inflows should now be utilised to beef up the portfolio's equity component. But the same needs to be done in a planned manner. Sadly, the client has not even set himself any concrete objective in terms of planning for retirement or providing for children's education. In other words, it's yet another case of investing randomly without setting any objectives. To complicate matters, the client has erred by investing nearly Rs 30 lakh (Rs 3 million) in just 2 diversified equity funds, again pointing to lack of diversification.
The solution -- set tangible objectives (in monetary terms) and then invest in well-managed equity funds in a disciplined manner for achieving the same. This will help on various levels.
First, the enhanced equity component will ensure that the portfolio becomes well-diversified across asset classes. Second, it will make the equity investments diversified across multiple schemes. Finally, it will aid in gainfully utilising the surplus monies.
On the insurance front, the client is woefully underinsured. Considering that he is the sole earning member in the family, the ideal choice would have been to opt for a term plan. Term plans are pure risk cover plans; they offer the opportunity to obtain a high insurance cover at relatively lower premiums. After getting himself adequately insured, savings-based products like ULIPs should have found place in the portfolio. The client should rectify the anomaly by buying a term plan and fortifying his insurance portfolio.
The liability side could do with some rework as well. While the home loan can aid in tax-planning (interest and principal repayments qualify for deduction from gross total income), we aren't quite convinced about the loan against mutual fund investment.
The client is sufficiently liquid and certainly doesn't need to shoulder the burden of a redundant loan repayment. He would be better off paying off the loan at the earliest.
The client's financial status and condition make rather interesting reading. On the surface, we have an individual, whose income streams more than make up for his expenses, whose asset portfolio seems rather well-stocked. In other words, it's a seemingly picture perfect situation. But scratch the surface, and a radically different picture emerges.
The investments are lop-sided in favour of a single asset class (i.e. property). Despite the needs being long-term in nature, the client is virtually unprepared to meet those needs; in fact, he hasn't even quantified his needs -- which should be the starting point for the exercise.
He doesn't have an adequate insurance cover and has in his books avoidable liabilities.
The case only underscores the difference between 'having finances' and 'being financially sound.' And missing out on the latter could well mean that one is headed for a financial disaster.
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