May 30: According to a Standard & Poor’s Rating Services Global Financial Literacy Survey, around 76% of Indian adults do not understand key financial concepts such as risk diversification, compound interest and inflation.
Such financial ignorance can have costly implications when it comes to savings and investments. For instance, small savings instruments and bank fixed deposits (returning 6.25-7.60%1) are the preferred savings avenue for most Indians, yet few investors realise that if inflation trends at ~5%2 per annum, these may not generate enough returns to create wealth for the long term.
Similarly, they fail to understand that despite being volatile, the equity asset class has the ability to generate higher returns in the long term. In light of this, the need for financial planning acquires even greater urgency. This article looks at how investors can adopt financial planning to achieve their goals at every stage of life.
Need for financial planning
Lack of social security net – Unlike developed countries where citizens are covered under various social security services, India still has a long way to go. For instance, in the US, there is the Old-Age, Survivors, and Disability Insurance (OASDI) programme that provides financial support to individuals who are retired, disabled, or are the surviving beneficiary of a deceased individual. India too has recently announced many such programmes but coverage may not be sufficient due to factors such as rising life expectancy levels and decline in the traditional joint family system. Hence, it becomes even more imperative for every one of us to plan for our finances prudently to avoid future uncertainties.
Traditional savings bias – The Reserve Bank of India’s data on gross financial savings of Indian households shows that demonetisation has resulted in a greater financialisation of savings with the share of currency in household savings declining in 2016-17. Nevertheless, Indians continue to prefer bank FDs, which accounted for 60% of gross financial savings in 2016-17, up from 41.08% in 2015-16. While bank FDs with their safety of capital may be appropriate for near-term goals, they may not create sufficient wealth in the long term after discounting inflation.
Unfocused investing – When it comes to investing, many aren’t sure about quantifying their future goals be it short or long-term. Further, many of us have a poor understanding of risk. Understanding one’s risk-taking appetite is pertinent to avoiding sub-optimal investment decisions. Typically, a young investor, who has higher risk-taking ability, should allocate a bigger sum towards the equity asset class, which has the ability to generate higher returns in the long term as compared with the debt asset class. Unfocused investing typically increases the chances of goals remaining short of adequate funds.