As we are all aware, saving is very different from investing. Only when the saved money starts growing can it be classified as an investment. However, while taking an investment decision there are so many various asset classes and options available we often tend to get confused and start straying away from our goals. Unless we are able to put all these together and make sense of them it is extremely hard to make a good investment decision.
Let us not jump into classifying investments right away. Before getting there, we need to classify these needs that that prompt us to invest in the first place. The needs that prompt us to invest can be extremely diverse ranging from a short-term need to saving for a medical emergency going all the way to saving up for a retirement fund.
At Bombay Capital Services, we have constructed a helpful framework to get investors thinking about their investment needs and goals. We divide investments into four different levels, wherein each level is more fundamental than the one after. Only once the needs at the lower levels are met must an investor move onto the next level in the hierarchy. This system could
be recognized as the “Hierarchy of Needs” a concept proposed by Abraham Maslow. Maslow’s hierarchy explains the gamut of needs, ranging from basic ones such as food, clothing, shelter and moving onto more complex ones such as self-actualization. The basic idea explained in Maslow’s Law of Hierarchy is that people only strive to achieve higher needs once the simpler ones are satisfied.
So here is the Bombay Capital Services “Pyramid of Hierarchy”
Level 1- Basic Contingency Funds.
This is the basic cash flow required to take care of any sudden expenses or personal emergencies that may arise. It must be available instantly, partly in physical cash and partly parked in instruments such as auto sweep fixed Deposits & liquid funds. Online banking and ATM services make these easily accessible. We recommend between 4 & 6 months of expenses must be parked in such avenues.
Level 2- Term Insurance
A generously realistic amount of money that would be required by your dependents to finance their short-term expenses and goals if you were to drop dead or be incapacitated due to an injury or disease must be secured in term insurance. Adequate term insurance is a must be before you start investing.
Level 3- Savings for Short-Term Goals
Short Term goals refer to any planned expenses that one plans to make within the next 2-3 years. Part of these funds must be in minimal risk avenues that enable you to withdraw them as and when required.
Level 4- Long-Term Savings and Goals
Unlike level three these are larger expenses with set goals and targets ranging from 3 years onwards, they could even be as far away as twenty-five years. In order to achieve such goals, an investor has to be invested in Equity & Equity Backed Instruments such as Mutual Funds. It is quite easy to imagine levels beyond these. The concept is more important than the details. Depending on the individual circumstance of the investor they might need to modify some of these concepts and levels. For example: if the investor does not have any dependents they do not need to buy a term or life insurance or the investor might have enough income-producing assets making insurance less valuable. The goal of this framework is not to explain where and how much must one invest. Instead, this framework is built to explain the importance of completing one level before moving onto the next. Concluding that if you haven’t put emergency cash in a savings account, then don’t buy term insurance. Similarly, if you do not have term insurance do not start putting money in your son’s college education and so on.
Author: Rahul Goal