Mutual Funds Day 2: Savings vs Investments
Savings and Investments meant two separate things before Mutual Funds became famous. The main difference between them was Liquidity.
Savings came with a higher liquidity and lower yield whereas Investments came with a lower liquidity and higher yield. Liquidity means how soon you can withdraw the money and use it for a financial emergency. Yield means the returns on the investments — either dividend or capital appreciation.
“Do not save what is left after spending, but spend what is left after saving”. — Warren Buffett
“Saving is the foremost financial education we need, not finance.”
― John Joclebs Bassey
Savings and Investing were tracked as separate categories because the Poor had no option to Invest or build Assets. Investing was a Rich person’s game.
The various asset classes were
- Real Estate — Residential as well as Commercial.
- Gold, Silver, Precious Metals.
- Own a Business.
- Equity — Stocks of other Businesses.
- Bonds — T-bills, 10 or 30-year Government Bonds.
Savings on the other hand meant what goes into a bank account. The amount held in a savings account usually fetches an interest rate lower than the inflation rate. The standard savings yield is between 3 to 4% whereas Inflation is between 4 to 6%.
People also preferred to hold cash which meant they were getting zero yield. Holding cash was not a bad idea earlier because the transactions happened via exchanging cash. People used to buy things by spending cash. These days digital payments are picking up pace and the demand for cash is falling.
A Bank providing a Fixed Deposit with a sweep-in facility can be thought of as a new-generation savings scheme. You get a higher yield without compromising on liquidity.
Ideally, your Savings should have 6 months of your Active Income. If you get fired from your current Job you should be able to survive for this period before you can find a new one.
If it takes longer, you might most likely redeem your investments to meet the consumption demand. Ideally, the investments should not be redeemed prematurely. We should have the solvency and patience to let the investments run.
Savings/Emergency funds should be redeemed if the situation so demands. As it is a low-yielding financial instrument, you do not lose out on any opportunity costs.
After the launch of Mutual Funds, the fine line separating Savings from Investments has disappeared. People with a lower income were also able to participate in buying assets.
Let us revisit the same assets we discussed earlier :-
- Real Estate — REIT (Real Estate Investment Trust) Mutual Funds.
- Gold, Silver, Precious Metals — Commodity Mutual Funds.
- Own a Business — No coverage.
- Equity — Equity Mutual Funds (Index, Large Caps, Mid Caps, or Focussed Funds).
- Bonds — Debt, Gilt Mutual Funds.
Except for Owning a Business, every other category has a Mutual Fund using which you can purchase fractional units even if your income is low. For the same reason, MFs help the poor person more than the rich. A rich person can afford a dedicated Financial Advisor who plans the asset allocation. Whereas the poor may not be able to hire an advisor and any costs are a drag on their final invested value.
A regular savings program can also be handled via Mutual Funds these days. You could invest in a Liquid Fund or Overnight Fund that processes redemption within a day. The returns could be in the range of 4 to 7% depending on the fund and this could prove to be a hedge against inflation. Even then holding a small percentage of savings via cash is not a bad idea. Nothing beats cash.
What percentage of your income should you Invest/Save?
The answer depends on your consumption pattern. The higher your consumption expenses, the lower will be your savings. Consumption expenses usually go up when your income rises but after a threshold, you will be able to save more.
The common consumption expenses are:-
- Food & groceries (Vegetables, Fish/Meat, Rice, Wheat, Grains etc)
- Accommodation — Rentals or Maintenance.
- Travel for work — Vehicle EMIs, Fuel Expenses.
- Clothing.
- Support services like Electricity, Telephone, Internet, Gas, Water etc.
- Tuition Fees for Children.
- Interest Payments on Debt.
- Misc. expenses like Dining out, Medicine, Leisure, Vacation.
If you take a look at this list closely, most likely the entire income is spent on these essential items that households are left with no option to save. The Ultra Poor might end up borrowing money to meet the essential needs.
The money left over after the consumption needs could be saved and that is why it is called disposable income. If you are financially well-off you will be able to save more.
A better alternative would be to save a fixed percentage say 20 to 30% of your income first via SIP and that too in the first few days of a month. This will force you to live below your means and reduce unwanted consumption expenses.
25% to 30% savings/investing rate is a very good ratio. A person earning Rs 1,00,000 per month should be able to save Rs30,000. It may not seem a great deal at the start, but over time the corpus will get built and soon you will be able to generate passive income. Of this 30000 per month, 25% i.e Rs7500 can go into a savings fund with high liquidity, and the rest 22500 can go into high-risk Equity funds.
Once your Emergency fund reaches Rs6,00,000 ie 1 lakh monthly income X 6 months, you can divert the Rs7500 savings plan to high-risk, high-return Equity category.
In case you exhaust your savings fund due to an emergency, say medical expense or car breakdown then you should restart the Rs7500 contribution till the fund attains Rs6,00,000 value.
If you get a promotion of 10% over the next year, the revised investment amount should be 30% of 1.1 Lakh = 33000 per month and your emergency fund should have a value of 6.6 Lakhs.
In case you get a bonus or a windfall gain, it is better to wait out 3 days before doing anything. This will help you control impulse spending. Another option is to park it in a highly secure money market or liquid fund till you create a plan.
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