Q1. What is the difference between a financial plan and an investment plan?
We often use the terms investment planning and financial planning interchangeably. But there are major differences between the two.
The primary difference is in the focus area. Financial planning provides the wider framework, while investment planning zooms in on the execution.
Financial planning answers questions like: When do you want to retire? How much funds will you need at retirement? What’s your risk appetite? What are the plans for short- and long-term goals? Are the goals crisis-proof?
Investment planning is more concerned with the detailing of the assets—mix, returns, diversification, and so on. The investment plan serves as the pathway to achieve the financial plan goal. One takes ingenuity while the other takes careful execution.
Financial planning is about gazing into the future. It strategizes for situations like your child’s university education (18 years away), or your retirement (not before 30 years). Is it practical to plan for an eventuality that far away in the future? That is precisely what financial planning entails! It assumes that a decent approximation is better than a blind leap without any plan.
Investment planning adopts a smart, short approach. It evaluates how various classes of investments like debt funds, equity funds, gold funds, and liquid funds will perform in the years to come. It then analyses how all these factors will influence your journey towards achieving your goals.
A financial plan is usually fixed. Once you’ve established your financial plan, you should respect its sanctity for several years, without making frequent changes. One situation for reviewing the plan would be if there is a major transition in your life or if there is a significant change in your financial situation. On the other hand, if there’s a structural change in asset class returns, that would be a valid reason for re-examining your financial plan.
In contrast, investment plans always need to be re-examined. In fact, it’s best to review an investment plan at least once every year. This will help rebalance the investment plan based on current events. A change in asset values, poor performance of asset class, or macro changes are all conditions that necessitate a rebalancing of the investment plan. Rebalancing and revising your investment plan is a great strategy to move towards your goals smoothly and speedily.
Like a fingerprint, a financial plan is unique. Their circumstances may be similar, but the same financial plan is unlikely to work for two individuals.
An investment plan, on the other hand, can serve as a template and can for many with similar profiles and needs. Depending on the broader goal, it could be designed as a mix of equity and debt.
To summarise, a financial plan is a broad framework that defines your objectives, while the investment plan is effectively an action plan to achieve the financial freedom as conceptualised by the financial plan.
Q2. I have heard about two types of portfolio management: passive and active. What is the difference?
The performance of mutual funds depends on the approach adopted by the fund manager. There are two distinctive styles of investment management—passive and active.
Passive management
Under passive management, the fund manager’s objective is to construct a portfolio that seeks to equal the return on a given market index. The fund manager simply invests and allocates money among various indices according to the investment objectives of the fund.
For example, assets of an equity fund may be invested in Sensex or Nifty stocks in the same proportion of market capitalization as that of the index components or as per the number of stocks in each industry category included in the index.
Alternatively, if the index stocks are too many, the fund manager can purchase a statistically representative sample of stocks whose combined total return come close to that of the index. The choice of this sample is important and can require some amount of research into the behaviour of index stocks. This approach does not require any bargain hunting, and the expenses involved are low. This is more suitable for income-oriented, close-ended funds.
Mutual fund schemes adopting the passive management strategy are popularly known as index funds.
Active management
An active fund manager seeks to outperform a particular index based on constant reviews, and frequent re-balancing or shuffling of the portfolios. While constructing the portfolio, the fund manager looks at various aspects like holdings with different risk characteristics, changes in the economy, shifts in the business cycles, etc. These factors normally have a major impact on the market and subsequently on the portfolio holdings.
Whatever the style of management, the financial planners and investors will have to judge the kind of investments the fund manager prefers and try to see if the investor’s objective aligns with that of the fund.
Passive portfolio management
Passive portfolio management refers to a portfolio management strategy that seeks to replicate the risk and return characteristics of an index or market sector by matching its composition.
In passive portfolio management, the portfolio manager deals with a fixed portfolio designed to match the current market scenario.
Active portfolio management
In the active portfolio management strategy, the investment manager makes specific investments to generate more returns and/or create less risk in comparison to the benchmark index.
In this case, the investment manager exploits market inefficiencies by purchasing securities that are undervalued or short-selling securities that are overvalued.
The main differences
| Passive portfolio management | Active portfolio management |
| Index-linked returns | Aims to out-perform the market |
| Involves lower costs | Involves higher costs |
| Replicates a chosen index | Stocks carefully selected and timed |
Q3. What are Shariah-compliant mutual funds?
Shariah-compliant mutual funds are investment funds governed by the requirements of Shariah Law based on the religious principles of Islam.
This law requires you to be ethically and socially responsible when you invest your money. You must follow a certain set of principles. These include:
Prohibition of interest
Paying and receiving interest is prohibited under Shariah. It follows that investing in companies which earn or pay interest is prohibited. However, every company earns interest in some form or the other or has borrowings on which they pay interest. Therefore, to be more practical, limits are placed on the debt levels and interest income, and investments are made only in those companies that meet the criteria.
Prohibition on investing in certain businesses
Shariah prohibits investing in companies which derive most of their income from sale of alcohol, pork products, tobacco, gambling and nightclub activities, abusive drugs, military equipment or weapons and other such products.
Prohibition against investing in anything but the “real” economy
This principle bans investments in derivative products, hedge funds and structured products.
If you are interested in gathering more information about Shariah-compliant mutual funds, please consult a financial advisor.
Q4. I am 20 and I want to start my investment journey. I want to ensure that I don’t regret my financial decisions in the later years of my life. Can you help?
Technology has made it easier for people to know about different financial products available in the market. You must also be familiar with different investment styles and their benefits.
As a young and early investor, you are advised to keep some factors in mind to ensure your investment journey is successful for years to come.
Start early
Nowadays, most young investors tend to start their investment journey some five years (or more) after they start earning. They feel their income is too low to bother about investing. What they do not realise is that by waiting, they are losing precious time to grow their wealth. Time matters a lot in building a healthy corpus even with a small initial investment. As income increases, the investment could also increase.
Create an emergency fund
Anyone could face an unexpected situation any time in life, like a medical emergency. One should always have sufficient money set aside (enough to meet expenses of two to six months) as an emergency fund for a secure life. When you do not have such a backup, it becomes necessary to borrow or to sell off some assets, both of which can hamper your financial journey. Please remember to consider all factors relevant to you before you arrive at the right quantum of emergency fund.
Take sufficient insurance
An adequate amount of life insurance and health insurance can have a major impact on your life. While a health insurance policy helps ensure a medical emergency does not deplete your wealth, a life insurance policy safeguards your dependents, should something happen to you. Please consider inflation when you decide the sum insured so that there is adequate protective cover for you and your family.
Spend judiciously
In the heady rush of getting their first salary, young people tend to spend more, thinking they can always save later. In some cases, they even spend more than the amount that they earn (credit cards and buy-now-pay-later offers making it easier to do so). Social pressures tend to derail their financial journey. It is best to follow the advice of Warren Buffet: “Do not save what is left after spending but spend what is left after saving.” This will help you build more wealth faster.
Maintain a proper asset allocation plan
Asset allocation refers to dividing the investments across different asset classes like equity, debt, gold, etc. This is one of the most important investment strategies as it helps the investor to keep a balance between risks and rewards. Without thoughtful allocation, your portfolio tends to become imbalanced and more vulnerable to extreme swings in the market. Also, your capacity to take risks (your risk appetite) and your priorities will change over time. Therefore, you must review and revise your asset allocation accordingly.
Want to take the safest route to wise investments? Take the help of a competent financial advisor right from the beginning of your financial journey.
Q5. How do I assess the performance of a mutual fund?
Does the mutual fund you have chosen a good fit for you? There are many factors to understand the performance of a mutual fund, let’s look at a few simple ones.
Identify your goals
Know the purpose of your investment. Goal-based investing involves a wealth manager or investment firm that is focused on helping their clients reach their specific goals rather than just generate the highest possible return. Does this suit you?
Shortlist and compare peer funds
It's difficult to judge a mutual fund on its own. So, you should always make a small list of similar funds and continuously compare those. If you are investing through a wealth manager or investment firm, then they will take care of comparing the performance of the scheme.
Historical performance
Each mutual fund comes with a disclaimer stating that past performance is no indicator of future performance. But past performance does help us understand how the scheme has performed across different market cycles. A consistent performance shows the skills of the fund manager. Pick a scheme with lower risk and better return.
Fee structure
Mutual funds charge fees including advisory fees, operational costs, investment management fees, registrar and transfer agent fees, legal and audit fees, sales commissions, ongoing service charges, etc.
These fees may be regular or direct. Regular mutual funds are sold through distributors and agents and the cost includes fees or brokerage costs. On the other hand, direct funds are bought from the asset management company without any intermediaries. Therefore, the commission and/or brokerage component makes regular funds more expensive. It follows that the returns from direct funds are more than those from regular funds.
Comparison with the benchmark
Investors can compare the performance of schemes with benchmarks like BSE Sensex Index, S&P CNX Nifty, etc. Comparisons with similar funds across different times yields a good picture of a mutual fund’s performance.
International Money Matters Pvt Ltd is a SEBI registered investment advisory firm. If you have any personal finance queries, click here to talk to advisors from IMMPL.
Note: This story is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.
