KARACHI: Perhaps the single biggest reluctance that people have to invest, particularly in riskier asset classes such as stocks, is the following question: “what if I need to take my money out and use it?”
This week’s column will try to answer that question by recommending a strategy that allows investors to separate their short-term needs from their long-term investment objectives. The strategy revolves around the use of different classes of mutual funds. As promised last week, this column will also offer advice on how to select a mutual fund to invest in.
Different strokes for different folks
Investors tend to grow more risk averse as they grow older and with good reason. The older an investor, the closer they are to retirement and the fewer risks they can afford to take. For this reason, many asset management companies in the United States create retirement funds that are specifically designed to become more conservative as the investor grows older, allocating more towards fixed income rather than equity.
To recap, fixed income refers to bonds, bank deposits and other types of investment that deliver a fixed return. They are generally safer, though they yield lower returns, generally only marginally above inflation. Equity refers to stocks, which are significantly riskier, but tend to have the highest returns over a longer period of time.
While there is no specific rule, a good rule of thumb to remember is the following: assuming a 40-year career, start off with 100% in equities and move 10% of your total retirement funds into fixed income for every five years along your career path. So for example, somebody with 10 years on the workforce should have 80% in equity and 20% in fixed income.
Add a further 10% in fixed income at the half-way mark of your career and then continue until retirement when 100% of the portfolio should be in fixed income. Other, more aggressive advisors would say that a person should stay 100% in equities until the final 10 years of their career, when they should start switching over.
There are merits to both arguments and investors would do well to consider which one suits their own personal investment philosophy.
How to select mutual funds
There is a list of mutual funds available on the website of the Mutual Funds Association of Pakistan that lists all funds by category and by performance over the past one year.
The major categories of funds are the following:
1. Equity funds
2. Balanced funds/Asset allocation funds
3. Income funds/Money market funds
As may be evident, balanced funds and asset allocation funds are hybrids between fixed income and equity funds. The difference between balanced funds and asset allocation funds and between income funds and money market funds are relatively minor, particularly in the context of the Pakistani capital markets.
As for how to select funds, I would recommend selecting from the list and then going to the asset management company’s website and looking at the long term performance of the fund. If the fund’s fiveyear or longer average return looks reasonable, then it is probably a good fund to invest in, though of course there is never any guarantee.
But what if I need my money? As for how to go about investing in riskier assets while retaining liquidity, I would recommend creating accounts in a personal financial ledger (you should really have one if you don’t already) for each major life expense – retirement, down-payment for a house, children’s education, etc – and then create a separate account for rainy day savings.
Then, based on the time till maturity (18 years till your child goes off to college, 25 years till you retire, for example), select one or more mutual funds to invest in. The closer you are to maturity, the more you should allocate to fixed income. The further away you are, the more you should invest in equity.
For the rainy day fund, invest about 6 months’ salary in a money market fund. It yields much more than a savings account or even a term deposit and has the advantage of being tax free up to Rs300,000, which a savings account or term deposit is not.
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