The interest rate cut by the RBI could have unintentional side-effects on your life goals; it could impact your investment portfolios. In this article, we discuss how rate cuts can affect your investment portfolios and your current lifestyle.

Low-returns environment
When you create an investment portfolio to meet a goal, your primary objective should be to achieve it without high investment risk. So, higher the goal priority, lower the risk you should take.

Viewed in this context, interest rate cuts could subject your high-priority goal-based portfolio to high risk. This is because such portfolios will predominantly contain bonds and a small portion of equity.

Assume a case where you need ₹1 crore to fund your child’s college education 10 years from now, of which at least ₹75 lakh should be in the education investment account when your child enters college. This means you have to invest a significant proportion of your monthly savings in bank deposits so that you accumulate ₹75 lakh in 10 years. The rest of your monthly savings can be invested in equity to accumulate the balance ₹25 lakh to achieve the best-case goal of ₹1 crore.

The problem is that if interest rates are cut, you need to invest more capital to accumulate ₹75 lakh. This means you need to save more. And saving more means reducing current consumption. This means you may have to reduce not just your discretionary expenses, such as fine dining or vacation, but also non-discretionary expenses, such as groceries.

But that is not the only issue. You cannot bridge the shortfall caused due to rate cuts by investing more in equity.Volatility in the equity market has increased sharply since 2008. This has negative implications on your goal-based portfolio.

Investment capital
The asymmetric effect of investment returns described above does mean that you should always carry low proportion of equity investments in your portfolio. You may choose to invest more in equity if you have goals of low priority, where you can take some risk.

So, low-return environments primarily subject your high-priority goal-based portfolios to high risk.

High-priority portfolios during your working life can be typically your child’s education portfolio and your health care portfolio. In both cases, the issue is compounded by the fact that health care inflation and education inflation are much higher than the typical household inflation. If you are retired, rate cuts could affect your lifestyle and health care portfolio.

So, what should you do to reduce the impact of interest rate cuts on your high-priority goals? Given that you cannot take high risk on the portfolio meant to meet critical life goals, you have two choices.

One, you can reduce your current consumption and save more, especially when you are closer to achieving your life goal. For instance, you may want to increase your investment contribution to your child’s education fund when you are within three years of achieving the goal. And two, you can bridge the investment value gap by transferring money that you have set aside for other low-priority goals to the investment account meant for the critical goal. This can be done when you have a year to achieve your life goal. Or you can choose to do both.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in

B Venkatesh
This article was published on November 22, 2015, in BusinessLine (The Hindu)