How to protect your money goals in a volatile stock market – Create a cushion for goals | The Economic Times
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Create a cushion for goals
Like most humans, the stock market too has its fair share of mood swings. Doing so, it can torpedo your critical financial goals, if you are not sufficiently protected. Goals are planned on the basis of certain assumptions, and if these go wrong, the final outcome can be very different and rather shocking, especially if you are closer to the respective goal. In sum, building an adequate buffer is the best way to protect your goals from market ups and downs.
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How much do you require?
A thumb rule recommended by many financial experts and advisors is that you should create a cushion of 15-20% of the future goal’s value. For example, if you have estimated a need of Rs 20 lakh in 10 years, invest such that you earn at least 15% more, which in this case amounts to Rs 23 lakh. Even if the assumed return or inflation stray off the mark, you will attain your goal.
Also read: 5 golden rules when stock picking in a volatile market
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Besides this thumb rule, there are several other factors that determine how you should calculate the size of your cushion. These are-
Importance of goal: The more critical your goal, the larger your created buffer
Time horizon: You need a small amount for a goal with a flexible deadline or where the money is needed over a longer time frame. You need a bigger buffer where the deadline can’t be extended
Nature of withdrawal: The buffer will depend on whether you want the entire money at one go or in instalments
Asset class: You need to be cushioned more if you are trying to achieve goals through volatile asset classes like equities.
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Reduce the need for cushion
Creating a cushion means investing more but what if you don’t have the necessary funds in the first place? You can reduce the need for a cushion by having a very strict exit or reduction strategy. If you are using the mutual fund route, SWP or STP can be good exit or reduction tools if the market plummets at a time closer to your goal. If the stock market is down by around 50% from its high, a one-time withdrawal at this point can be disastrous. Creating a clear reduction strategy also helps you manage your entry and exit without being affected by emotions. When should you start equity reduction? Use 20% of the goal period formula. For a five-year goal, the shift to safer asset classes can be done during the last year, for a 10-year goal, it can be done in the last two years, and in the last three years for a 15-year goal.
Also read: Stock market investing: How to plan a successful exit strategy
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Assume less to reduce cushion
The need for a cushion typically arises because most assume a return of around 15% from equities and 8% from debt. The average, however, is only around 12%. So investors need to temper their return expectations from equities. Note that the 12% return is before tax and one needs to adjust for the LTCG tax of 10%. The reduction in aggregate returns because of the shift to debt close to a goal is another factor. Taking a realistic approach to inflation is another way to reduce the need for a cushion.
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How to manage the cushion
No, this cushion is not the same as your regular contingency fund or emergency corpus. Since it is a part of long-term goals, it should be invested in growth assets like equities and debt. Should you manage these cushions as part of goals or at an aggregate level? Experts say it is better to go with the aggregate strategy as it gives the advantage that the additional gain in a goal can be shifted to the aggregate cushion and used later. Considering the overall situation at the individual or family level gives a lot of flexibility.
Also read: Why you need an emergency corpus and where to invest your money to create one
