Savings options for young parents

Ensuring that children are financially secure in future is one of the top priorities for parents. It is quite natural that, at some point, questions related to this responsibility arise, and there is confusion about the right investment choices to make. I'm a parent myself and I have gone through this situation. Trust me, saving money efficiently hinges upon two things, both of which are in your control - time and discipline.

My aim in this article is to point you in the right direction for saving and creating wealth for your family.

Let us take discipline first.

If you were to think about 'savings' in terms of a mathematical expression, how would you put it? Most likely you would say Income - Expense = Savings.

If we go by the above equation, we are essentially prioritising expenditure over savings. Many people end up spending significant amounts on lifestyle accessories - an overpriced phone, for instance, or a fancy handbag. There is no harm in giving in to your desire for something new, except that it eats into the 'savings' portion of your financial plan. This leads to two serious problems - savings are below potential, and inconsistent.

So how do we deal with this? Quite simple - we just need to rearrange the equation to read: Income - Savings = Expense.

By rearranging the components, we are essentially prioritising savings over spending. This means that the moment the salary is drawn, funds should be diverted towards savings. Whatever is left over is to be spent. Adopting this approach as a way of life requires tremendous self-control and discipline. It implies that you cannot pick up a fancy phone just because it makes you look fashionable. You will be forced to sacrifice instant gratification for a bigger benefit which you will be able to enjoy many years later.

The second important aspect is time. The sooner you start saving, the better for you and your family. I regret not doing this myself. My elder daughter is six years old now. I started saving for her only from her fourth birthday onwards. I wish I had not wasted the initial years.

What difference will a few years make, you may ask. Let me tell you a story to help you understand the enormous impact of time on savings.

A father gives his three young daughters pocket money of Rs. 50,000/- each, every year, for life. They are free to use this money in any way. They are also given an option to invest it in a 10% interest-bearing instrument, with the condition that the investment should not be touched till their 65th birthday.

Here is what each daughter does with her money -

• The eldest daughter saves a total of Rs. 4,50,000/-, starting from her 20th birthday till the 28th one. She enjoys the remaining cash flow for the rest of her life.
  
• The second daughter spends the cash flow initially, but on her 28th birthday she decides that she too needs to save the same amount as her elder sister. It takes her till her 36th birthday to save Rs. 4,50,000/-.
  
• 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/-
  

Given that the investments grow at the rate of 10% year on year, can you guess how much each daughter will have when she turns 65? The answer may surprise you.

• The eldest daughter's investment of Rs. 4,50,000/- grew to a whopping Rs. 2.5 crore.
  
• Although the second daughter had saved the same amount as her elder sister, her investment grew to only Rs. 1.18 crore.
  
• The youngest saved much more than the others, but she still could not match her eldest sister's achievement. Her investment grew to Rs. 2.0 crore.
  

So, starting early in life makes a huge difference.

I was not smart enough to start saving right from the time I was 20 years old and I'm guessing not many reading this would have done so either. Given this situation, what do you think is our best option now?

Well, here is a bitter pill - we now have to do what the youngest daughter did, because her investment strategy resulted in the second-best result. To generate a significant amount of wealth for our families, we have to save continuously.

There is a twist, though - the only thing that can compensate for lost time is higher 'Rate of Return'. So essentially we should look at investing continuously in instruments which can yield higher rates 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 pursuit of the goal of 'saving for the child'.

1. Insurance-linked 'child' plan: Run away from agents who try to peddle such plans 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, and a series of cash inflows is expected after 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 realise that the rate of return on these instruments is mediocre, sub 8% in most 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 generate great returns.
   
2. Savings Bank: Many parents open a bank account in the child's name and start hoarding cash in it. Cash in savings accounts creates an illusion of safety. In reality, it is probably the worst form of investment. Inflation is real and inflation will eventually vaporise your money's purchasing power as a savings bank account yields about 4% interest while the average inflation rate is about 6.5%. This means you are losing about 2.5% by parking your money in a savings bank.
   

So, what are the other investment options at your disposal? Here are a few:

1. Equity oriented Mutual Funds (50%): Many people find it scary to invest in a Mutual Fund. The usual feeling is that as mutual funds invest in stocks, and stocks are volatile, it is easy to lose money. Investing in equities requires a change of mindset. Yes, stocks are volatile. The only antidote to volatility is time. If you give your mutual fund investment adequate time, you can expect a great rate of return. Historically, average returns of mutual funds over a 15-year period (in India) have been more than 14%, which is brilliant! There are funds which have delivered over 20% as well. I strongly suggest you save up to 50% of your investable cash flow in equity-oriented mutual funds, via the SIP route. Most importantly, you need to give this investment time - at least 10 years, in my opinion.
   
2. Fixed Income (30%): I'm not talking about the regular bank fixed deposits here. You should explore options beyond those and venture into AAA-rated corporate bonds. Some of these bonds give you over 10% interest. Besides, an AAA-rated bond implies there is a great amount of capital safety.
   
3. 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 great extent, maintains the purchasing power of money. But do not over-expose in gold. A ceiling of 10% would be apt.
   
4. Index ETF (10%): Young parents should consider an exposure of at least 10% in an Index Exchange Traded Fund (ETF). The rationale is very simple: an index like Nifty 50 represents the 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 realised, the portfolio I've suggested is skewed towards equity. I believe that over the next few years, equity as an asset class will outperform every other asset class in India. Good luck!

Karthik Rangappa is the Vice President, Educational Services, Zerodha.