How to minimize risk in the circle of wealth

Dhan Chakra, or the circle of wealth, is a system that gives one a mind map of a life cycle of money flows and the place of various financial products in it. We looked at an Income Box, that fills due to the conversion of our labour into money. 

The surplus over all living expenses from this fills the Wealth Box, which aims to swell in size such that once we stop working, the income from this box can keep us eating till we die and then leave something over for the squabbling siblings.

Last week, we were at the point when the savings from the Income Box were moving towards the Wealth Box. But before they enter, they need to transform from cash (that loses value due to inflation and taxes) to something that will generate a surplus or grow in value after inflation and taxes are taken into account. 

It is this decision of transforming the money in the bank into a mutual fund, a stock, an insurance plan, a pension plan, gold or a plot that is one of the toughest to make. This transformation is the key determinant to how big and steady the Wealth Box will be. How soon you can stop going to work just to fill the Income Box. And whether you will travel the world at 60 or count each note and coin.

The first rule when buying a product to convert cash into a Wealth Box product: don’t buy something that throws off income today. Our human capital is still getting converted to cash, through work, and we want to hoard such that the Wealth Box is big enough to see us through our non-working silver years. This leads to a need for products that build a corpus, or a large sum of money, rather than give an immediate return.

For example, instead of a Post Office Monthly Income Scheme that gives a guaranteed return each month, a large lump sum can be converted into an instrument that will grow over the years, like an equity mutual fund or if you are zero risk, a National Saving Certificate.

Divide up the products you buy into four buckets. These are called: No-Risk, Market-Linked, Real Estate and Gold. Into the No-Risk Bucket goes your provident fund contributions (that earn 8.5% tax-free currently), public provident fund contributions (8% tax-free), any other small saving products such as National Saving Certificates. 

It is easy to recognize a zero-risk product, just find out if the return is fixed in percentage terms and the time of the investment in months or years. In a No-Risk Bucket will go products that have no surprise at the end of their lives. The usual rate of such return is 1 percentage point higher than inflation. The function of this bucket is to provide the Wealth Box with stability.

Into the Market-Linked Bucket go products such as equity, balanced mutual funds and direct stocks. These have the ability to make the box grow much faster than the products in the No-Risk Bucket. But why do we want risk at all? Isn’t it safer to be safe? 

The average return from the Indian equity market has been around 15% a year over the last 30 years. The most misguided investor, who invested at the market peak of 3 April 1992 at the height of the Harshad Mehta bull rally, is up an average annual 8%, and this is not taking into account dividends. 

And a person who has regularly put in Rs1 lakh each year into the Sensex for the last 20 years is looking at a corpus of Rs1.3 crore today. But we got to hold our money and faith for at least 10-12 years for equity to give its return kicker. 

For direct stock pickers, the returns can be much higher or much lower. The safer way to fill the Market-Linked Bucket is to stick to broad index-linked products, so that the risk due to too few stocks is removed and since an index will always hold some of the best companies of a market, and the return stream is fairly predictable.

The Gold Bucket is small. It does not take more than 10% space in the Wealth Box. Its chief purpose is to keep a small liquid fund of money that is free from the risk of inflation. So you can add it to your Risk-Free Bucket, except that, for Indian families, this could be the pool that will fund the gold that our big fat weddings consume. Instead of gold coins or even chains, buy gold exchange-traded funds—they are cheaper, safer and much more liquid. 

The Real Estate Bucket remains tinted with black in India. The high transaction costs, understated property values and laborious legal system makes real estate as investment a messy asset to have in your box. Unless you are able to deal with the high transaction costs in terms of money and time, keep the bucket filled with the one house that you live in.

The size of the buckets and how steadily we fund them will determine the size of our Wealth Box when we quit working. At that point, the corpus is used to buy income-generating financial products that keep the Income Box tinkling and our cappuccinos coming. Maybe with no sugar now!

Source: http://www.livemint.com/2009/08/04222453/How-to-minimize-risk-in-the-ci.html?h=B