As a young parent, it is quite natural if you have had those sleepless nights worrying about money and savings for your child. Questions such as, how much money is required by the time your child turns 21? how to generate so much money? how much to save? where to save? and a chain of other related questions ensures you stare at the ceiling all night long. Well, as daunting as this may seem, trust me, saving money efficiently hinges upon two things, both of which are in your control – time and discipline.
I’m a parent myself and I have gone through this rigor. My aim in this article is to help you get started and point you towards the right direction of savings and wealth creation for your family.
Let us deal with discipline part first.
If you were to think about ‘savings’ in terms of a mathematical expression, how would it look like?
Most likely you would say -
Income – Expense = Savings
Like many, if you too think the above expression makes sense, then I’m afraid you’ve got it all wrong. If we go by the above equation, then we are essentially prioritizing expenditure over savings. Agreed expenditure over daily essentials is necessary, but many end up sending significant amount of money over lifestyle habits. Think about the all the times you have bought that overpriced phone, or a fancy handbag, or a fancy camera, or a fancy sunglasses. Each month the desire to own or experience something new and fancy slowly creeps in and we succumb. There is no harm doing this, after all you are spending your own hard earned money. The problem however is, it eats into your ‘savings’ portion. This further leads to two serious problems – we save way lesser than what we are capable of saving and we save inconsistently.
So how do we deal with this? Quite simple, we just need to re arrange the
above equation –
Income – Savings = Expense
On the face of it, the re arranged equation appears very straightforward, but trust me; it makes a sea of difference. By rearranging, we are essentially prioritizing savings over spending. This literally means, the moment we draw our salary, we first divert the funds towards savings and spend whatever is left after saving. As you can imagine this is a very big deal. Adopting this approach is a way of life and requires a great amount of sacrifice and a greater amount of discipline, simply because you will have to live by the rules of this equation month on month, for many many years. This, by no means is an easy task. This implies that you cannot go out there and pick up a fancy phone just because it looks fashionable in your hands. You are now forced to sacrifice this instant gratification for a bigger benefit which you would enjoy many years later.
The second important aspect is time. The sooner you start saving, the better it is for you and your family. In fact, I regret not doing this myself. My elder daughter is 6 years old now and one of my biggest ‘financial regret’ is that I wasted the initial four years by not creating a savings plan for her. I started saving for her only on her 4th birthday onwards.
What difference this makes, you may ask. Well, it makes a massive difference. Let me tell you small story to help you understand the massive impact of time on savings.
A father gives his three young daughters a lifelong pocket money of Rs.50,000/- each, every year. They are free to use this money in any which way they decide. They are also given an option to invest this money in a 10% interest bearing instrument but with a condition that the investment made should not be touched till their 65th birthday.
Here is what each one does with their money –
The eldest daughter decides to save money very early in life. She saves from her 20th birthday to 28th birthday. She saves a total of Rs.450,000/-. After making her savings, she enjoys the remaining cash flow for the rest of her life.
The 2nd daughter enjoys the cash flow first, but on her 28th birthday she decides that she too needs to save the same amount as her elder sister. She saves all the way till her 36th birthday, saving a total of Rs.450,000/-.
The youngest daughter also starts saving her money from her 28th birthday onwards, but she decides to save all the money she receives until she turns 65. Her total savings amounts to Rs.19,50,000/-
As mentioned earlier, investments grow at ‘very moderate’ rate of 10% year on year. Now, here is a question for you - can you take a guess on how much each person’s investment would grow to on their respective 65th birthday?
This may surprise you -
Eldest daughter’s investment of Rs.450,000/- grows to a whopping Rs.2.5 Crore
Although the 2nd daughter saves the same amount as her eldest sister, her investment grows only to Rs.1.18 Crores
The youngest saves a lot of money but she still cannot achieve what the eldest daughter achieves with her investment. Her investment grows to Rs.2.0 Crores.
Interesting right? Starting early in life makes a huge difference, so much so that the youngest daughter’s massive investment of Rs.19.5 lakh (made over her life time) still cannot beat the eldest daughter’s meager investment of Rs.4.5 lakh made early on in life. As you may have realized, time, is making all the difference here.
I’ve not been smart enough to make savings I was 20 years old and I’m guessing not many reading this would not have made either. Given this, what do you think is our best option now?
Well, here is bitter pill – we have to do what the youngest daughter did, because her investment strategy resulted in the 2nd best result. To generate significant amount of wealth for our families, we have to start saving continuously. I know these sounds like a long and boring plan, but well, there are no alternatives!
But here is a twist – the only thing that can compensate for lost time is higher ‘Rate of Return’. Higher rate of return, can significantly compensate for the lost time. So essentially we should look at investing continuously in instruments which can yield higher rate of return.
This leads us to the million dollar question – where should we invest?
Before we get into that, let me tell you what most parents do in their pursuit of ‘saving for the child’. This, frankly in my opinion is a financial sin, please do not commit it.
Insurance linked ‘child’ plan – Run away from agents who try to peddle these insurance linked savings plan for your child. Insurance is an expense and it cannot double up as an investment, whichever way you look at it. Typically, these plans come with an annuity component, wherein a series of cash flow is expected when your child hits a certain age. The annuity component makes young, financially gullible, parents believe that the future cash flow would come handy when the child starts higher education. However, if you break down the numbers you will realize that the rate of return on these instruments is mediocre, sub 8% in most of the cases. There are two serious problems with such ‘investments’ – you not only commit large amounts of money every year (for many years) towards such low yielding avenues, but you also lose out on many attractive investment opportunities which can otherwise generate great returns. Please avoid this and liberate yourself from such long, pointless financial commitment.
Savings Bank - Many parents open a bank account in the child’s name and start hoarding cash in the account. Cash in savings account creates an illusion of safety. In reality, money in savings account is the probably the worst form of investment. Inflation is real and inflation will eventually vaporize your money’s purchasing power, and you won’t event realize this. As you may know savings bank account yields about 4% return, the average inflation rate is about 6.5%, this means you are losing about 2.5% by parking your money idle in a savings bank account. A futile venture if you ask me.
So what are the other investment options at your disposal? How should parents build a portfolio for their child? Well, here is what you can look at doing.
Equity oriented Mutual Funds (50%) – I understand that many people find it scary to invest in a Mutual Fund. The usual thought is that mutual funds invest in stocks, and stocks are volatile therefore it is easy forone to lose money. Yes, they are volatile and that is the nature of the beast. Imagine, if you had an option to see the valuation of your apartment on a daily basis. Naturally, the price of your apartment would vary (1Cr today, 95L tomorrow, 1.05Cr day after) – would you consider this volatile? May not be, as we believe real estate is the safest bet over the long term. Likewise, investing in equities requires you to change your mindset. Stocks are volatility and the only antidote to volatility is time. If you give your mutual fund investment adequate time (which you should) then you can expect a great rate of return. Historically, average returns of mutual funds over a 15 year period ( in India) have been in excess of 14%, which as you can imagine is brilliant. Of course, there are funds which have delivered over 20% as well. I’d strongly suggest you save upto 50% of your investable cash flow toward equity oriented mutual fund, via the SIP route. Most importantly, you need to give this investment time, at least 10 years in my opinion.
Fixed Income (30%) – By Fixed income, I’m not talking about the regular bank fixed deposits. You should explore options beyond this and venture into AAA rated corporate bonds. Some of the AAA bonds give you over 10% interest, which I think is great for a fixed income return. Besides, a AAA rated bond implies there is a great amount of capital safety. Keep an eye out for these corporate bonds and consider investments in these instruments.
Gold (10%) – Don’t expect gold to deliver spectacular returns over the years. At best you can expect an average of about 6-8%. But you need this investment as a hedge against inflation. Gold to a large extent maintain the purchasing power of your money. Do not over expose yours investment in Gold, I’d advice not more than 10% allocation to gold.
Index ETF (10%) – By definition an exchange traded fund (ETF) should just replicate the returns of its respective underlying. For example, an Index ETF like Niftybees is supposed to mimic the performance of the Nifty 50 index. I think young parents should consider an exposure of at least 10% towards an Index ETF. The rational is very simple; an index like Nifty 50 represents the broad Indian economy. If you believe the economy will do good going forward, then naturally the index will also do well. If the index performs well, so will its ETF.
As you may have realized, the portfolio I’ve suggested is skewed towards equity. I personally believe that over the next few years, equity as an asset class will outperform every other asset class in India. This is not a blind faith, but rather an outcome of a well structured thought process. Perhaps discussing this thought process itself will be another article, for another day.
Karthik Rangappa, VP – Educational Services, Zerodha