Understanding Medium Term Needs

Many experts typically term needs arising in 4-8 years as medium-term needs. They have distinct characteristics.

Growth with capital preservation

In periods of four years and more, inflation comes into play. This means at 5% annual inflation, a budget of Rs 1,000 today will be able to then buy what Rs 781.25 does today, or almost 22% less. Better way to show is rupee losing its value. Today’s 100 rs. Will be tomorrow’s 85 rs./- For large amounts, this cannot be absorbed from regular pay. Lower risk, lower return investments like traditional instruments and short-term investment plans like debt mutual funds, get impacted by inflation. (The above is an illustration and provided for understanding purposes. The returns can vary depending on the market conditions)

Limited capacity to withstand volatility

Medium term needs often cannot be deferred and provide limited headroom to withstand adverse effects of market conditions on investments.

Implications For Investments

For medium term needs, you need higher risk investments with potential for higher returns. They also need to be less volatile than investments with high growth potential like equities and equity mutual funds like index funds, large cap mutual funds, mid cap mutual funds and small cap mutual funds.

Experts suggest a mix of debt and equity investments. More the time at hand, greater the equity investments, as with time one can ride out the short-term turbulence. The question then is how can a person have the right combination of debt and equity investments? Thankfully, certain types of mutual funds can help. However, we suggest you to kindly consult your financial advisor before investing.

How Mutual Funds Can Help ?

Preponderance of choice:

Investors can choose hybrid funds which invest in varying combinations of debt and equity for needs arising in 5 years or later. The choice can be based on factors such as time at hand and risk appetite. For needs arising in 3-4 years, investors may consider longer term debt mutual funds such as medium duration debt funds. They carry lower risk than equity-oriented hybrid funds but higher risk than short term debt mutual funds.

Among hybrid funds, two popular categories merit a brief discussion. For a financial goal 6-8 years away, one may consider a balanced advantage fund. If you are wondering “what is balanced advantage fund?” the answer is that it is a mutual fund that invests 40% to 60% of its money in equities. It also invests in debt and arbitrage. Debt investments help control volatility while the equity portion has the potential for long term growth.

The fund manager has the freedom to change the mix investments in asset classes and categories depending on market conditions and opportunities in line with the Schemes asset allocation table. Thanks to this approach, balanced advantage fund returns typically experience lower volatility than equity mutual funds and can be considered for needs expected to arise in 6-8 years.

Another hybrid fund, Equity Savings Scheme, primarily invests in equities and derivatives besides in debt investments. While equity, derivatives and debt investments play the same role as in Balanced Advantage Fund, the equity portion is typically lower, which lowers the growth potential but still tends to beat inflation. Such funds can be considered for goals 5-6 years away.

Varieties of debt mutual funds also exist but typically for needs arising in 3-4 years, medium duration debt mutual funds may be considered.

Some of the Benefits of expertise:

Individual investors typically do not have the time and expertise to track developments in equity and debt markets and make the right decisions, which mutual funds can.

Facilitates regular investments:

Mutual funds help in regular investments by the investor with SIP, with SIP full form being Systematic Investment Plan. For those uninitiated to SIP meaning, it involves regular investment of a pre-decided amount in a mutual fund scheme.

The SIP investment process, with amounts as low as Rs 500, helps buy more units when the market is low and less units when the markets are high due to compounding. Consequently, the average cost of buying units becomes low in the long term and you gain when the markets rise.

Helps provide regular income:

Apart from regular investments, mutual funds can also seek to create regular income with Systematic Withdrawal Plan (SWP) facility which redeems units over regular periods, say every month, to generate regular income.

Equity Tax advantage:

Hybrid mutual funds investing 65% or more in equities are subject to equity mutual fund taxation. This means capital gains from investments of 1 year or more are treated as long term capital gains. The capital gains exceeding Rs 1.25 lakh in a financial year are subject to 12.5% for long term capital gains tax with capital gains up to Rs 1.25 lakh being tax free.

Capital gains from investments less than one year old are treated as short term capital gains and need to pay short term capital gains tax of 20%. Equity mutual fund taxation is advantageous for those in the highest 30% tax slab.

Choosing The Appropriate Mutual Fund For Medium Term Needs

Determine the amount required:

This is the target amount for the financial goal that you need after accounting for inflation.

Time horizon and risk appetite:

The time left to save money and the ability to manage the market turbulence impacts your investment choice. One can take the help of a qualified mutual fund advisor for this purpose.

Examine performance track record

After zeroing down on the mutual fund category compare past performance of the funds over 1, 3 and 5 years with respect to individual scheme benchmarks and peer funds. This will help zero down on the fund for you.

Determine regular investment amount

Based on a realistic expectation of potential returns, arrive at the SIP investment amount.

Clearly, a combination of planning and regular investments can go a long way in fulfilling your medium-term needs and make you go to parents with surprise gifts instead of seeking financial help.