The most important trade off that is made in any investment decision is the choice between financial and human capital. Financial Capital represents the current wealth of the investor. Human capital, on the other hand, represents the future earnings potential of the investor. The total wealth of an individual is the sum of financial capital and human capital.
When an investor is young, the financial capital is low, and the human capital value is high. This equation changes with the passage of time. Usually, to hedge against the loss of human capital, insurance is an effective risk-mitigation tool. The current pandemic has exposed the mortality vulnerabilities significantly and has brought to the forefront an important question: Lost the earning member of the family? How should you use his/her insurance/retirement/inherited money?
It is more important to understand the goals that the family is trying to achieve.
They may be living expenses of the family, education needs of the children, servicing existing mortgage obligations or any other necessary expenses for the sustenance of the family. It is important to understand that the risk appetite is low, and the desire is to have a regular income stream and protect the investment principal.
I am assuming here that there is no pension or pension equivalent in sight. This background will now help you appreciate the fact that the investment options available would be low-risk investment products that would be spread among fixed deposits with scheduled commercial banks, low-risk gilt funds and at best some medium risk debt mutual funds.
If there is a regular income stream such as pension or pension equivalent from some insurance company in the form of an annuity, then the investment options available, while still low-risk, could include some growth mutual fund options as well as bullion. Traditional wisdom and proven research have established that asset allocation contributes to 90 percent of your returns and 10 percent are about the selection of the specific security.
Our conversation here is focused on helping you get the 90 percent piece right. Let us understand the pros and cons of each suggested asset class that can be considered for investment.
Fixed Deposits of Scheduled Commercial banks: From a systemic risk standpoint, Scheduled Commercial Banks are safer options for fixed deposit investments. While the Reserve Bank of India is strengthening its hold over the co-operative banking segment, it would be worthwhile to focus on reputed scheduled commercial Banks for Fixed Deposit investments and not invest in Co-operative Bank Fixed Deposits for some time till systemic stabilization kicks in for Co-operative Banks. Fixed Deposits offer you safety, liquidity and regular return, depending on the frequency of interest payments.
Gilt Funds: These mutual funds invest in government securities. These government securities have a sovereign backing and are safe investment options for funds investing in them. With yield curve management being the key focus area of the Reserve Bank of India over the next 12 to 18 months, given the need to revive the economy over that time period, gilt funds would offer steady returns with limited volatility.
Bullion: Physical Gold or Gold ETFs can act as inflation hedge. This is an option that only those investors with lower liquidity needs can consider, on account of the regular income stream available to them through pensions of deceased earning members. The Securities and Exchange Board of India (“SEBI”) has risk categorization mandatorily provided for all schemes. It would be worthwhile for every investor to be aware of the risk rating of the scheme to assess alignment to their investment objectives.
The key to any investment that you as investors need to remember is that investment is a very personal decision and should be aligned to your own needs. This suggestion does not come from any finance books that I have been fortunate enough to read, but comes from the teachings of my grandmother, who lost her husband, the only earning member, very early in her life.