How to make your financial plan: 4 amazing steps to find out right mix of equity and debt

Your financial plan is all about a trade-off between risk and returns. Not just that, you also need to impute liquidity needs and tax considerations. Equity offers you tax efficiency and long-term wealth creation. On the other hand, debt offers stability and regular income. How you strike the right mix between equity and debt will depend on four factors.

Risk appetite and how it evolves

When you are in your mid-twenties or mid-thirties, your risk appetite is much higher compared to a 50-year-old person. When you are younger, you should allocate more to equity and less to debt. As your age progresses, at regular intervals you should reduce equity exposure and increase debt exposure.

Wealth creation needs

If you are looking at a larger corpus in the long term towards your retirement, children’s education and marriage, etc, you must have a larger allocation to equities. Equities are risky in the short run. However, if you hold quality equity funds for a longer tenure, then empirical evidence shows that equities have vastly outperformed other asset classes. Further power of compounding ensures higher wealth generation through equity over long term.

Changing liquidity needs

How exactly does liquidity determine your debt or equity mix? If you need the funds back in 10 years then equity can be a good option. If you need the funds after three years then equity may be too risky and debt funds may be a better option. But, if you need the funds in less than one year, then even debt or income funds may not be advisable due to price volatility. You will be better off investing in liquid funds or liquid-plus fund.

Your tax considerations

When you plan for the long term the post-tax returns matter more than the pre-tax returns. If you are already paying high taxes on your income, your key priority will be to make your financial plan as tax-efficient as possible. Relatively, equity is more tax efficient than debt. When it comes to equity funds, the dividends are entirely tax free in your hands as are long-term capital gains (held for more than one year). Even short term capital gains are taxed at a concessional rate of 15%. And if you want to add the Section 80C benefit, you can opt for ELSS. For debt funds, dividend is tax free but there is DDT to the extent of 28.33%. Additionally, STCG are taxed as per your income slab rate while LTCG is taxed at 20% after indexation. Equities are surely more tax smart.

The writer is head of research & ARQ, Angel Broking