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How much returns should you estimate for your goals?

This article helps you estimate the returns from your investments to help you decide how much you need to invest.

How much returns should you estimate for your goals?


Posted on 15 Mar 2023
Author: Sayan Sircar
11 mins read
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This article helps you estimate the returns from your investments to help you decide how much you need to invest.

How much returns should you estimate for your goals?

Summary:
  • We provide guidance on how to estimate the returns from investments to determine how much you need to invest.
  • The process involves choosing the assets, using a mix of equity and debt assets, and balancing the investor's goal priority and the time horizon of the goal.
  • We have provided tables to interpret the range of returns for different risk levels and time horizons.
  • We conclude by providing a worked-out example that shows the derisking of the asset allocation as the goal comes closer and how this reduces the average return.


📚 Topics covered:

What is return estimation for financial goals?

What are financial goals

Once you have fixed a goal amount and target date, say 60 lakhs in 10 years, you need to determine how much returns you are expected to get over these 10 years to reach the target of 60 lakhs.

Goal-based investing process

This return estimation step lets you determine how much you need to invest today as a lump sum and regularly every month.

Return estimation is part of Step 5 of the goal-based investing process described here: I am now ready to do goal-based investing. What now?.

What happens if you use a simple return estimate like 12% for goals?

Goal-based investing process

The above image, from the Groww website, is a simple SIP calculator. The 12% return assumption is an average figure that gives a false impression that the investment will grow smoothly like an FD. In reality, if you are investing in the stock market, the return looks like this:

Reality of stock market investment

Each of those lines is a portfolio whose ending value is unknown today on the starting date.

Related:
The lie of wealth-creation via SIP in mutual funds

We have covered the concept of goal-based investing that converts the journey from the above to this:

Investment result for goal-based investing

Read more on goal-based investing here: I am now ready to do goal-based investing. What now?.

Did you know that we have a private Facebook group which you can join for free and ask your own questions? Please click the button below to join.

How to choose the investments for your goal?

To determine the return, you need to choose the assets first. We will use a mix of equity and debt assets, both investible via mutual funds, for our goals. The basic premise of asset allocation is a balance of the investor’s goal priority (needs vs wants) and the time horizon of the goal like this:

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Goal-based investing: priority vs. asset-allocation

Here are some sample asset allocations depending on the risk profile and duration of the goal. Before using them, investors should understand their risk profile using a tool like this and be comfortable with the amount of risk they are taking.

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Sample strategic asset allocation

You can read more on the concept of asset allocation here: What should be the Asset Allocation for your goals?. Once the asset is fixed, the next step is to create a glide-path to manage risk.

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Glide-path for goal-based investing

The image shows the glide path of a medium goal that starts at 60:40 and is step-wise reduced as the goal comes closer. It follows the same allocation numbers in the “Medium” case in the table above as described in detail here. The key takeaway is that asset allocation is not constant over the life of the goal due to a risk called sequence of return risk since the stock market is unpredictable. Therefore, just starting a SIP and increasing the SIP by 5-10% does not imply that you will meet the goal. This concept of rebalancing and review is discussed in more detail in this post on reviewing the goal’s progress.

How to estimate returns once asset allocation is known?

Using some assumptions below:

  • equity 11% return at 15% risk
  • debt 4% return at 0.5% risk these are the expected yearly return ranges for each of the SAA numbers given in the previous table:
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Sample strategic asset allocation return range

The range is determined as:

  • lower return value = -4 * risk + return
  • higher return value = 3 * risk + return

The way to interpret the table is that, for example, for the medium-risk 10-year goal, the SAA is 30:70, and the return for that particular year can be between -8.2% to 15.6%. But, of course, this is an estimate. The actual return for a 30:70 goal may differ from the values given above, depending on market conditions.

The return numbers in the table above are still a range and are not helpful yet. We will perform one more calculation to get a single number for the entire investment since asset allocation changes throughout the life of the goal.

We have assumed that equity as an asset class gives a return, called the risk premium, higher than inflation.

We will combine the risk premiums with inflation like this:

Expected return = (1 + Inflation) * (1 + Risk Premium) - 1

We get for a 60:40 asset allocation, the expected returns, with 7% inflation and risk premiums as 3% and -3%, respectively, as:

Equity return = 1.07 * 1.03 - 1 = 10.21%

Debt return = 1.07 * 0.97 - 1 = 3.79%

60:40 portfolio return = 0.6 * 10.21 + 0.4 * 3.79 = 7.642%

While this value of 7.642% is higher than inflation, we progressively reduce the asset allocation to more conservative values as the goal becomes closer. This derisking reduces the average return from 7.642% to a lower figure.

Time left Equity % Debt % Weighted return % Average return % Real return
25 60% 40% 7.642% 6.166% -0.779%
24 60% 40% 7.642% 6.105% -0.836%
23 60% 40% 7.642% 6.039% -0.898%
22 60% 40% 7.642% 5.967% -0.966%
21 60% 40% 7.642% 5.888% -1.040%
20 60% 40% 7.642% 5.801% -1.121%
19 60% 40% 7.642% 5.705% -1.211%
18 60% 40% 7.642% 5.598% -1.310%
17 60% 40% 7.642% 5.479% -1.422%
16 60% 40% 7.642% 5.345% -1.547%
15 60% 40% 7.642% 5.194% -1.688%
14 54% 46% 7.257% 5.021% -1.849%
13 48% 52% 6.872% 4.851% -2.008%
12 42% 58% 6.486% 4.684% -2.164%
11 36% 64% 6.101% 4.522% -2.316%
10 30% 70% 5.716% 4.365% -2.462%
9 24% 76% 5.331% 4.217% -2.601%
8 18% 82% 4.946% 4.078% -2.731%
7 12% 88% 4.560% 3.955% -2.846%
6 6% 94% 4.175% 3.854% -2.940%
5 0% 100% 3.790% 3.790% -3.000%
4 0% 100% 3.790% 3.790% -3.000%
3 0% 100% 3.790% 3.790% -3.000%
2 0% 100% 3.790% 3.790% -3.000%
1 0% 100% 3.790% 3.790% -3.000%

For a single-payment goal, which can be invested using a Target Date Fund, will have an expected return equal to the Average return % figure in the table above.

A worked-out example

Let’s take the example of reaching 60 lakhs in 10 years. As per the table, we will need to assume that the expected return over this period is 4.365% or approximately 4.4% and use that in any SIP calculator. If you use the Arthgyaan goal-based investing calculator, then the calculator will handle the return estimation on its own with these inputs. The returns for equity and debt are assumed to be 11% and 4% on an average post-tax and the SIP amount is stepped-up by 5% per year.

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SIP calculator with rebalancing and glide-path

Using the Arthgyaan goal-based investing calculator, we will see that the SIP amount for reaching 60 lakhs in 10 years will be around ₹32,500/month. The ₹32,500/month amount should be increased by 5% a year.

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This post titled How much returns should you estimate for your goals? first appeared on 15 Mar 2023 at https://arthgyaan.com


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