Vinod's Finance Page

Basic Financial Planning

A step by step financial plan for Non Resident Indians (NRI) planning to return back to India

1. Basics
2. Setting Goals
3. Establishing an Emergency Fund
4. Funding Short Term Goals
5. Asset Allocation Plan for Long Term Goals
6. Maintaining Your Asset Allocation
7. Common Investor Mistakes

1. Basics

No one would rush to buy building materials for a house without first planning and developing a detailed plan for it. Yet investors frequently buy and sell stocks without having any plan. This is exacerbated by sheer quantity of advice of questionable quality from a vast financial services industry with deep conflicts of interest. Often the interests of the financial services industry and investors are in direct conflict with each other. This makes investors vulnerable to a variety of poor investment decisions with disastrous financial consequences.

Fortunately investing is a simple process despite frequent attempts by wall street to convince investors otherwise.

Saving vs Investing
Saving and Investing represent two distinct ways of managing money. Understanding the difference helps you make informed choices for your financial needs.

Saving means seeking to preserve assets that you accumulate over time. Stability of principal is a higher priority than return potential. Principal is guaranteed but offer only very low return potential. There is a risk of principal not keeping up with inflation resulting in loss of purchasing power.

When you invest your money, you are seeking growth. Investing usually involves greater risk to principal than saving and offers higher return potential. Principal is not guaranteed but it offers possibility of higher returns with greater inflation protection.

Why Should You Invest?
Investing is a good tool for building up the funds needed for buying a house or putting children through college. Long-term investing is an essential element of retirement planning, since most people do not have pension plans or cannot accumulate enough savings without some long term growth of principal.

Risk and Reward
One of the more basic relationships in investing is that between risk and reward. Investments that offer potentially high returns are accompanied by higher risk factors. There is no free lunch. This is the cornerstone of modern finance and forgetting this often gets investors in trouble. High returns and low risk just don't go together. Don't waste your time looking for any such investments. If you do find one, it is a scam.

Basic Investment Options
There are three basic asset classes that one can invest in are
1. Cash
2. Bonds
3. Stocks


Asset Class Comparison
Asset Class Historical Returns Maximum loss in one Year Comments
Cash 3-4% NA
The risks are low and principal is preserved, but cash equivalents generally do not provide returns high enough to outpace inflation especially after tax.
Bonds 4-6% -15.5 Bonds represent loans to a government or business. They offer limited potential for increasing returns. Rising inflation can cause substantial losses.
Stocks 10-12% -38.6  Stocks represent ownership of a company and are a claim on the corporation's earnings and assets. Historically, stocks have provided the best opportunity for long-term growth of principal. Very volatile in short term.

Risk is part of the investment process. Risk is never going away and any investor who thinks he has eliminated risk is just fooling himself. Risk in its most basic form means possibility of losing some or all of the original investment.

From the prespective of an investor risk takes three basic forms and investments should be choosen to balance aganist each of these risks.
1. Market Risk: Volatility of your investments. Your investments could go down in value just when you need them. Stocks have high market risk, bonds have low market risk and bank savings accounts have zero market risk.
2. Inflation Risk: Inflation reduces the purchasing power and over the long term could severely reduce the value of  your assets. Seemingly safe savings in bank accounts have a high inflation risk.
3. Currency Risk: The currency of your investments might lose its value.

2. Setting Goals

Before you start any investments you need to have a clear understanding of what your financial goals are.

The first step in this process is to list all your assets and liabilities. Then calculate your net worth and your net liquid assets (cash, stock, bonds).

The second step is to create a list of your goals along with estimates of how much is needed for each and when you plan to reach them. Examples of goals are downpayment for a house or car, kids college tution, retirement, etc.

3. Establishing an Emergency Fund

The main reason to set up an emergency fund is to help you to meet your monthly expenses in case you lose your job. So how much you save in the emergency fund is primarily determined by how long you expect to be able to find a new job. Three to six month of living expenses should be set aside for this purpose. It would be a good idea to have a separate account from your regular bank account for this purpose so you would not be tempted to use this money for other needs. This should be in a taxable account as you would not be able to withdraw money quickly from a tax sheltered account like an IRA or a 401K.

A money market account would be an excellent choice. Personally I would recommend Vanguard Prime Money Market fund. A key factor in this selection is your access to this money. You should have instant access to this money since you would be using this primarily for emergencies. Other slightly more aggressive options include using a short term bond fund like Vanguard Short Term Corporate or an I Bond. Choose the one you are comfortable with, there is no one right way for this.

4. Funding Short Term Goals

Identify your short term goals like saving for a house, a car down payment or money you plan to take back to India within a short term. These are goals for which you expect to spend money within the next 2-10 years. If you do not have any such goals you can skip the rest of the section.

Calculate how much you need for all of your short term needs. Determine how much you need to save each month to reach your goal. Then choose how you need to invest based on the following table.

Criteria for Choosing Asset Classes
Time Frame If you goal is more than 5 years away you can consider investing 20-40% in stocks. For less than 5 years you should be in CD/Short Term Bonds/I-Bonds/EE-Bonds.
How flexible are you regarding time frame. If you willing to be postpone your goal by a few years in case of investment looses you can consider investing in stocks.
Need to take risk If your goal can be achieved without any need to take risk then you can avoid investing in stocks. The difficult case is you are planning to build a dream house and more often then not you can always use a little extra money. In this case you can invest a small portion in stocks (20%). 
Relative size of the goal compared to long term portfolio. If your short term goal is only a small fraction of your retirement goal you can take more risk. If you do suffer loses you can use money from retirement goal for the short term goal and avoid selling the losing investment in the short term goal.

If you do decide to invest in a portion in stocks, invest the very first few years into stocks and then invest the remaining in bonds. This would give the money invested in stocks to work longer for you. Choose the following for short term goals in increasing order of risk/reward. The only exception to this is I/EE Bonds which should be the preferred choice as they defer taxes.

1. I/EE Bonds
2. Vanguard Short Term Corporate or Vanguard Ltd-Term Tax-Exempt for 28% tax bracket and above
3. Vanguard Total Bond Market Index or Vanguard Ltd-Term Tax-Exempt for 28% tax bracket and above
4. Vanguard Total Stock Market Index
5. Vanguard Total International Stock Market Index

Start reducing your stock holdings 1-2 years before you plan to withdraw. The same steps as in the next section apply if you plan to hold stocks.

5. Asset Allocation Plan for Long Term Goals

Asset allocation is the strategy of dividing up your assets based on a tradeoff of risk and return. This is a central tenet of Modern Portfolio Theory which attempts to maximize your return for a given level of risk. Several studies have concluded that the most important determinant of a portfolio's return is its asset allocation. However asset allocation is still an art rather a science and it involves making personal choices to balance risk and reward

By combining assets with different characteristics in a portfolio an investor can achieve higher returns with lower risk over the long term. Adding high risk asset classes and investments to a conservative portfolio may seem risky but its effect will be to both increase returns and lower the overall risk of the portfolio. Each asset class has a different exposure to each specific type of risk. Dividing you investments into different asset classes reduces risk by balancing aganist each type of risk. Diversification is the investor’s primary defense against risk in their portfolio.   

Investors should use as few funds as possible in their portfolio to simplify management. A simply well diversified portfolio could be developed with as few as three funds representing US stocks, International stocks and bonds. Such a portfolio would by definition beat the returns of the average investor and over the long run can be relied on to beat 90% of the investors.

Developing an Asset Allocation Plan

An asset allocation plan should be chosen based on three criteria:
1. Need to Take Risk: The basic idea is that if your goal can be met without taking any risk then there is no need to take risk. Hence in this case we would choose a portfolio with very low risk. But for the majority of the investors there is a need to take risk as they would not be able to save sufficient money for retirement without some growth of principal.
2. Ability to Take Risk: A long investment horizon means you have greater ability to take risk. Investment horizon means how long you are planning to hold on to the investment. Suppose you  plan to take money back to India in three years when you go back, your investment horizon is only three years. Even thought you might plan to use it to fund a long term goal in India its invesement horizon in US is still three years (short term goal).  Hence it should be invested as a short term goal. When you have a very stable job with high earning potential your ability to take risk is high but if you have no source of income ability to take  risk would be low.
3. Willingness to Take Risk: Your tolerance for risk. Basically your ability to sleep well at night with the level of risk. A conservative person would be less willing to take risk and hence should have lower percentage of stock. Your risk tolerance is not static, it will change as your age.     

For a Non Resident Indian (NRI) planning to go back to India it would be a good idea to keep a portion of the investments in US. In this case you should consider only the portion that you plan to hold in US for the long term (10+ years) as long term investments in US. If you plan to go back to India in less than 5 years and do not plan on holding investments in US you should not hold any stocks. 

Take Advantage of NRI Benefits

After you return back to India for good you are treated as a Returned but Not Ordinary Resident (RNOR) for a period of 2 years. During this time all your foreign income is exempt from taxes in India. Once you return back to India and become a Non Resident Alien as per US IRS regulations you can also avail of several tax benefits of US. The most important of which are the 0% capital gains on stocks and mutual funds. You pay 25% on dividends.

This provides an ideal opportunity to convert all your retirement money (from 401K and IRA) into a taxable account. A suggested approach is to convert your 401K into a rollover IRA before you go back to India. Once in India you can withdraw this money (paying 10% penality for early withdrawal) and pay tax in a lower tax bracket. Depending on the the amount you have in your retirement account you can choose to withdraw this money in 1-2 years to avoid paying any tax to India. Thus it is a good idea to contribute to a 401K even if you plan to return to India in the near future.

For an average conservative investor one suggested way to allocate is to have a 50/50 stock/bond mix. Based on your ability, willingness and need to take risk you can increase or decrease the stock percentage in your portfolio. Within the stock portfolio it is better to allocate between 30-40% of the stock portion into international stocks. This is especially important for investors who might be spending the money finally in Rupees. Having atleast 15-20% of one's long term assets in international stocks provides good hedge against any dollar depreciation. Thus the final suggested portfolio is 35/15/50 US/International/Bond.

If you invested $10,000 in 1970 in 35/15/50 in US/Int/Bond mix it would be worth $264,000 as of December 2002.
This is an annualized return of 10.44% with 11.71% standard deviation. The best return in any year was 53.28% and the worst loss in any year was -23.57%.

You should be very careful in selecting your asset allocation. If you are not capable of handling a 50% loss of your stock investments you should reduce it to the level that you would be comfortable with. The time to decide your risk tolerance is before you make your first investment. Once you choose an asset allocation you should not change it unless need, ability or willingness has changed. But resist the temptation to change your asset allocation in an attempt to market time.


Risks of Market Timing

A study conducted by Dalbar found that between 1984-2000 the average mutual fund investor gained 141% while S&P 500 gained 1201% in the same time frame. Money market funds returned 161% during the same time frame. The study found that investors did not get the entire return because of failed attempts at market timing.

While asset allocation has determined the majority of the returns in theory (and would hold in practice if buy and hold is followed), in reality investor behavior is a much more important determinant of returns.

The idea behind market timing is to buy stock when prices are low, hold onto your investment until the market peaks, and then sell your stock investments moving into cash until the market hits bottom. It does sounds simple enough. But as shown above the consequences have been disastrous to investors. So resist the seductive call of market timing. You will be severely tested during bear markets when you would you distinctly get the feeling of flushing your hard earned money down the toilet. You should fight the impluse to rush into safe investments during bear markets.

It is important to look at the performance of the whole portfolio rather than focus on individual holdings. At any point of time some asset would be under performing and you should resist the temptation to sell the under performing asset in an attempt to buy it back later. Don’t let short-term volatility drive your long-term investment planning. Your best defense against a fluctuating market is a well diversified portfolio and a disciplined program of periodic investments.

Consider any stock/bond investments in India also as part of the total portfolio. Any type of retirement fund in India like Public Provident Fund should be treated as a bond holding in your portfolio. Any pension plans or annuities either in India or US should also be treated as bond holdings. Avoid holding large percentage (25% or more) of your total assets in Indian stocks. India does not yet offer the necessary level of  investor protection nor quick recourse to legal remedies in case of outright fruad. However stock/bond markets in India provide attractive investment opportunities for the careful investor. Stick to large mutual fund companies with large asset base and keep a close watch on expense ratios when investing in India.

Once you decide on an asset allocation write it down and sleep on it for a week. This would give you time to think and understand your risk tolerance. Most investors would realize their true risk tolerance only during severe bear markets. Many overestimate their true risk tolerance as it is difficult for anyone to accept that they are not daring risk takers. Financial planning is not an arena where you can bluff yourself.

Implementing your Asset Allocation Plan

Once an asset allocation decision has been made you can proceed with the mechanics of implementing your plan. Here we need to consider asset location and expenses for implementing the plan. Asset location simply means allocating your stocks and bonds between retirement accounts and taxable accounts. The optimal tax strategy is to allocate all your bond holdings in tax deferred accounts (IRA and 401K) and stock holdings in taxable accounts.
You can implement this plan at Vanguard by using these three funds
1. Vanguard Total Stock Market Index (35%)
2. Vanguard Total International Stock Market Index (15%)
3. Vanguard Short Term Corporate (50%) or I/EE bonds in taxable account

Why Vanguard?

The Vanguard Group is owned entirely by its fund shareholder - not by a separate company looking for profits.  Vanguard's profits accrue to the owners of Vanguard portfolios.  This unique structure enables it to offer mutual funds with the lowest expense ratios in the industry. In addition Vanguard offers a wide selection of index funds with low minimum investment requirements. For these reasons Vanguard should be the fund group of choice for all investors.

During the height of the Technology boom as almost every mutual fund company brought out new technology based funds Vanguard refused to follow suit. This is one example of its high ethical standards.

You can hold your investments in Vanguard after you go back to India. You need to fill out a change of address and a W-8 form before you leave.  


Follow these steps to implement you asset allocation plan
1. If you have an IRA or 401K invest your bond portion in these accounts. Select an any available short or intermediate bond fund.
2. If you do not have a tax deferred account or do not have a bond fund in your tax deferred account or you need to invest more money than you can fit into your tax deferred account, invest in I/EE bonds (or Vanguard Short Term Corporate if you do not want to invest in I/EE bonds or have maxed both I/EE bonds).
3. If you can invest more in your tax deferred account even after allocating the bond potion then invest in an index fund. Most plans have an S&P500 index fund and you can use this as a substitute for the Total Stock Market Index fund.
4. Invest the remaining amount with Vanguard in Total Stock Market Index and Total International Index fund.
5. Allocate your monthly investments in the same 35/15/50 ratio.

6. Maintaining Your Asset Allocation

Your asset mix should be periodically reviewed and rebalanced to in order for asset allocation to work best. Market fluctuation can easily throw your carefully planned asset mix out of balance. For example, if stocks outperform your other investments they may eventually represent far more than the original target percentage that you set up, which in turn could expose you to more risk than you would like. To bring your portfolio back in balance in this situation, you might choose to sell stock and reinvest in cash equivalents or bonds.

Set a specific day each year when you would review your portfolio against your asset allocation plan. Since rebalancing involves transaction fees and potentially taxes it should only be done with new investment funds are available or if your allocation differs by more than 5% from your target allocation. Say you have $100K with 50K stock and 50K bonds and the next year it becomes 45K/55K stock/bond then you should sell 5K worth of bonds and invest the 5K in stock. But if you are going to invest new money of 15K in the next year you can invest the first 10K into stocks only to make it 55K/55K and then invest the remaining 5K in 50/50 ratio between stock/bond. This rebalancing is more important between stocks and bonds than between different stock classes i.e. between US stocks and international stocks.

Sticking with an investment plan sounds easier than it really is. It is pretty simple to stick with your investing strategy when your financial and emotional life is happy and stable. However, it's the challenging times that you need to think about. An investment plan is successful only if you are able to stick with it through good times and bad. Altering your investment plan should never be done on a whim.

7. Common Investor Mistakes

Keep the following things in mind as you invest as these are some common mistakes new investors make.
  • Avoid sector funds, even if you think a particular sector would do well in future. A sector can have a very bright future yet deliver poor long term returns.
  • Avoid active funds at all costs. Active funds are much more expensive than their expense ratio indicates. Active funds add more than 1% in hidden expenses that can only be calculated by analyzing its financial statements.
  • Be wary of financial advisors. If you want to hire a financial planner read up on investing before going to the planner. Choose only a fixed fee planner.
  • Avoid the temptation to tweak your portfolio or alter your plan.
  • Avoid investing in individual stocks. Individual stocks have company specific risk that can be diversified away and thus there is no additional reward for taking this type of risk. While risk and reward are related, you are not rewarded for taking all types of risk. 
  • Ignore advice of mainstream financial press. They are in the business of selling interesting and captivating news not providing sound financial advice.
  • Watch the fees you are paying for funds. You should not be paying more than 0.5% in total fees as expense ratio,  brokerage costs or annual fees per year.
  • Do not postpone investments because you are afraid of market volatility. There will always be some event that is a cause for concern and if you allow this to delay your investment plan you will never be able to get started in investing. You will forever be waiting for the perfect time to invest.

Understand the Effect of Expenses on Returns

At first glance it would seem that a 1% additional expense for a financial planner or a active mutual fund is not a big deal. But even a small additional expense has a huge impact on final returns and comes as a shock to new investors. Say you invest $10,000 in an active mutual fund that has an expense ratio of 1% higher than an index fund or you pay this to an advisor. After 30 years your return would be $81,000 (at 7% return). The same amount without the additional expense would return $109,000, fully $28,000 more than the high cost fund. Note that this amount is much larger than your initial investment. Expenses are one of the few things under your control and you should strive to reduce them as much as possible.


Do not construe the information provided here as authoritative investment advice. All information provided or referred to on this website is for informational purposes only. It is not intended to be financial, legal, accounting or tax advice, nor should it be relied upon as such. Vinod is not a licensed financial planner.