The path to financial freedom

The start of the year is a time for making resolutions, setting goals and reviewing your financial health.

We tend to underestimate the power of planning for our financial future. A simple arithmetic tool will show it is never too early to prepare for one's golden years. It is called the power of compounding, which teaches us that the sooner we start saving (and investing), the faster we will become financially free.

Let us illustrate. A 19-year-old starts saving US$2,000 a year for seven years, which compound at a rate of 10 per cent a year. She stops making contributions thereafter, and lets the savings (parked in diversified investments) compound at the same rate.

A simple calculation shows that by first saving a total of US$14,000 in the first seven years of her working life, the savings would have accumulated to over US$1 million by the time she is 66 years of age.

Now let's take the case of her friend, who starts saving when he is 26. Assuming his goal is to save over US$1 million by the time he is 66, he will need to save US$2,000 for 41 years to achieve his goal, even when the savings compound at the 10 per cent rate. That's the advantage of saving and investing early.

Now, having built up a sizeable nest egg, how do you gainfully deploy the savings to become financially secure as soon as possible, whether in preparation for the more mature years of our lives or to financially secure the future of our children?

The most common practice is placing your savings in bank deposits. This is understandable, given the security offered by such deposits. However, it is important to look at the "real" returns on these savings after taking into consideration the rates of inflation.

Against this backdrop, when you consider capital preservation, diversification across several investment solutions becomes critical. Apart from bank deposits, one of the most common ways to preserve and increase wealth is through insurance solutions, such as annuities and endowments.

Insurance solutions, which are typically long-term in nature, offer defined returns after a certain date. The flip-side of this certainty is their lack of flexibility - you cannot access them easily in emergencies.This is where an allocation to a diversified basket consisting of stocks, bonds and precious metals is useful. These assets are more fungible than the usual insurance products and come in handy when you need to fund various life-cycle needs, like financing for the children's education or health emergencies.

For those who can, diversifying a part of your investments internationally would help spread the sources of risk. Research shows allocating part of your wealth in such diversified investment baskets is also key to boosting overall returns.

Historically, stocks have delivered higher returns than bonds (for instance, the diversified MSCI global equity index has provided returns almost nine times the original investment over the past 30 years, despite several major bear markets during that period). Hence, an investment basket consisting of 50 per cent stocks and 50 per cent bonds (or bank deposits) would provide a higher return over an extended time-period than one exclusively parked in bank deposits.

The traditional approach to allocating between stocks and bonds is to put a larger share of your investment capital in stocks compared to bonds during the early part of your working life. This ratio inverts as you heads close towards retirement and the need for wealth preservation becomes increasingly important.

A ballpark rule for the allocation between stocks and bonds has been to allocate (100 - your age) per cent to stocks. So, if your age is 40, the typical advice would have been to allocate 60 per cent of your investments to stocks. Of course, as life expectancy increases, this rule-of-thumb may need to be modified to increase the allocation to stocks, especially if you are looking at succession planning.

Meanwhile, we also need to consider the stage of the market and business cycle we are in to fine-tune our asset allocation between stocks and bonds.

Although the current global equity market recovery is the second-longest on record, recession risks remain muted due to a combination of loose financial conditions and earnings upgrades. This is supporting stocks and other risk assets globally.

With global growth expected to accelerate modestly and inflation to remain subdued, there is likely room for further upside for risk assets. This is not to ignore the higher asset valuations and the late economic cycle we are in, but synchronised economic growth and still loose monetary policies worldwide suggest risky assets may have more room to run.

This would justify a pro-risk tilt in our asset allocation. However, today's late-cycle conditions and low volatility place even greater importance on a broad diversification across asset classes and an overall emphasis on risk management.

A faster pace of removal of accommodation by central banks, excessive risk-taking, geopolitics and China's deleveraging and its likely impact on global trade and commodities are among the risks we need to monitor. In any case, given the run-up in markets, it is good discipline to periodically rebalance your allocation back to your target allocation to ensure it is aligned with your overall risk-and-return objectives.

In conclusion, securing your financial future starts with a well-thought-out plan, after considering your life goals. The next important step is to save and invest early. It is never too late to start, but if we are starting on financial planning at a later stage of our lives, we should ensure that our children start early.

Finally, by diversifying savings across various investment solutions, we can generate better risk-adjusted returns. This would go a long way in making us financially free to enjoy our golden years.

•The writer is chief investment strategist for Standard Chartered Private Bank.

A version of this article appeared in the print edition of The Sunday Times on January 14, 2018, with the headline 'The path to financial freedom'. Print Edition | Subscribe