Why should a declining stock market not bother you?

2016 has not turned out to be a great start for the capital markets. Story is no better when we look at the last one year's performance, a negative 15%. What does this mean for your portfolio? Often investors spend lot of time trying to decipher the impact of market movement on their investment decisions without understanding their own needs. Irrational reaction to market movements can lead to unpleasant investment experiences.

To have money in your hand every month does not guarantee you the lifestyle you anticipate throughout your life. Today's sound financial situation does not necessarily foretell an equally rosy future. A loss of income, even temporary, can eat into your savings or lead to a debt. An uninsured loss can wipe out your accumulated wealth. Insufficient savings can force a reduced lifestyle post retirement. Also, poor tax planning can result in paying higher taxes than what you are liable to pay. All this, combined with changes in your life cycle needs and/or external economic changes can make you and your future generations financially vulnerable. You need to plan and manage your current income and your future income according to your needs. These needs are your goals, your dreams. Planning and achieving your financial goals will provide you pleasant investment experience and not beating the market.

People who write their goals are much more likely to achieve them. Sit down by yourself or with your loved ones and start to imagine what all you want in your future. Consider what drives you in your life and how that has changed over time. Although each person is different and has different aspirations but to begin with, you can start by bucketing your financial goals into three broad categories: Essentials, market and aspirational.

Essentials bucket

At a minimum, you must protect yourself from the anxiety of a dramatic decrease in your current standard of living. Thus, you must immunize yourself from personal risk: the devastating impact of not being able to meet your essential cash needs, regardless of the performance of financial markets. Essentials are those requirements that you may have to meet regardless of your good or bad financial situation. At a minimum, you must maintain sufficient liquidity to meet your living expenses for at least six months. Retirement savings may also be part of your essentials bucket since it's an essential goal. You do not have a choice of not planning for your retirement.

Medical expenses would also increase as your age increases. You must categorise all your basic needs as your essentials. When you start planning your finances, filling your essentials bucket is your first priority. To meet your 'essentials' bucket, you need a portfolio that protects your capital and provides a return that is little more than the inflation. Liquid mutual funds, government of India bonds, fixed deposits and provident fund should ideally form a major part of your 'essentials'. And thus, a crash in stock market will not have any impact on your 'essentials' portfolio.

Market bucket

Once your essential requirements are met, you may want to maintain your lifestyle by earning a rate of return that is comparable to the market return. These requirements are not your essentials but rather more than essentials or safety needs. Planning for child's foreign education, going on regular vacations, buying an expensive car etc. are usually your 'market bucket' requirements. Since these are not your basic needs, you can plan to invest in instruments that can provide you market exposure. However, you cannot afford to take excessive level of portfolio risk even in market bucket. A diversified portfolio of equity and bonds is a reasonable investment for 'market bucket'. Some of the options could be ETFs, equity and balanced mutuals funds. Such a portfolio is expected to deliver a return that is closer to or a little better than the market return. Since the investments are exposed to market, this portfolio will have a market risk. Say, a current fall in Indian equities would have lowered down your 'market' portfolio return. There maybe short term volatility in equity investment but over a long period of time, volatility reduces. However, the current fall in Indian equities may also be viewed as an opportunity to get rid of any laggard in your existing portfolio. For example, if a specific equity fund has not delivered a better return than the benchmark, you can plan to shift into a better fund in the same category.

Aspirational bucket

As the name suggests, aspirational financial goals are created to enhance one's lifestyle. You will be able to fund your aspirational goals only when your essentials and market bucket requirements are fulfilled. Aspirational goals are motivated by the observation that sizable wealth creation requires higher level of risk. These investments can exponentially increase your wealth or there may even be a possibility of loss of principal. Since you desire to generate a return that is lot more than the market, a concentrated investment portfolio is recommended. Investment options for aspirational portfolio may include direct equity, early stage angel investing, real estate investment, hedge funds and even private equity. The basis of investing must be clearly understood before you plan to make these investments.

Since each of the three buckets will have a separate set of investment options, the return and risk profile will also vary. Therefore, any short-term volatility in the markets will not severely impact your overall portfolio. If you segregate your financial goals across these three buckets and invest accordingly, you will not feel the heat and get caught up with short term market volatility.

The writer is founder, ankurkapur.in, an investment management firm. He is a CFA charterholder from CFA Institute, USA and a CFP from Financial Planning Standard Board of India