Saving is a part of your income every month, that you put away regularly, does not necessarily provide returns and it can only meet your short-term needs. Investing on the other hand, provides returns and helps you grow your capital, which helps you fulfil your financial goals.
Decision to invest a big amount is a huge task. Your financial security depends on how much you invest and how efficiently you do so. If the call goes wrong, the investor bears the opportunity loss to earn better returns. Investment planning is a financial product that provides the opportunity to create wealth for future.
The Investing Dilemma with Deposits
Everyone wishes to earn better returns on their investments. But there is always a reinvestment risk which cannot be avoided. Interest rates have long cycles of rising and dropping, changes in the interest rates do not happen overnight and it cannot be predicted by an individual.
Mr.X invests Rs.50 lakh in a 3 year fixed deposit yielding 8.5% p.a. After 1 year, the interest rates go upto10% and after another 6 months to 10.5% p.a. With his existing deposit earning low interest rate, Mr.X decides to break the fixed deposit mid-way.
By doing so, he not only loses on the interest but also pays a penalty for early withdrawal.
Thus, how to plan investments in an efficient manner to lower the reinvestment risks?There is a way to balance the above situation and it is called Laddering. It is specifically applicable to fixed income options like bank deposits, recurring deposits, etc.
What is Income Laddering?
The idea is to create an investment ladder i.e., spread the amount to be invested into various blocks and invest them in different fixed income options, thus spreading them across various maturities to avail a guaranteed amount at the desired intervals.Example-
Continuing above example, Mr. X divides Rs.50 lakhs into 5 equal blocks i.e., Rs.10 lakh each. To create income ladder he keeps aside Rs.10 lakh for the current annual requirement. Then he invests Rs.10 in a 1 year fixed deposit, another Rs.10 lakh in a 2-year deposit and so on till he invests the last 5th block in a 4-year deposit. The invested amount gets matured in different years, thus he can re-invest them every year to lengthen the ladder as per requirement.By doing so Mr.X has following advantages-
- Minimised reinvestment risks- Laddering helps to use the periodic maturity proceeds and reinvest at least a part of the funds at a higher rate. Thus, he does not have to break his deposits and pay penalty. He can reinvest a part of his investment at higher interest rates.
- Liquidity- The income laddering strategy allows the investor to plan deposits at various intervals and access funds at different points of maturity without breaking his deposits.
Benefits of Investment Planning
The process of investing allows the investor to grow, rather than maintain, their savings for greater financial rewards in the future. Investment planning requires the analysis of many different investment options to choose the right vehicles for your assets, such as stocks, bonds, and mutual funds.