Investors and Their Financial Goals
- Focus Should Be on the Investor, Not Just Investments: Most investment-related questions overlook the individual’s specific financial needs and goals. Investment planning should start with the “why” — the purpose behind investing.
- Investment Motivations Vary: People invest for different life goals such as children’s education, retirement, home purchase, or regular post-retirement income.
- Defining Financial Goals: When specific amounts and timelines are assigned to financial needs, they become financial goals — e.g., funding education, marriage, retirement, or vacations.
- Goal Identification and Prioritization: It’s crucial to identify, prioritize (e.g., responsibilities vs. luxuries), and assign timelines to financial goals, distinguishing between urgent/important and non-urgent goals.
- Short-term vs Long-term Planning: Goals vary in timeframe — immediate (like income after retirement), near-term (buying a house), or long-term (education or retirement accumulation).
- Incorporating Inflation: Long-term goals must account for inflation, as the cost of goals like education or healthcare may increase significantly over time.
- The Pool Approach Limitation: Using a common investment pool without defined timelines may hinder goal-specific planning due to unclear investment horizons.
- Illustrative Case: Planning for Shalini’s education illustrates how ignoring inflation could lead to underestimating future financial needs.
- Cash Flow Mismatch: Most financial goals involve times when expenses exceed income, requiring prior investment to bridge the gap.
- Conclusion: Effective investment planning is about aligning investments with individual life goals, timeframes, inflation expectations, and personal priorities.
Factors to evaluate investments :
- Saving vs. Investing:
- Saving emphasizes safety and reducing consumption to accumulate funds.
- Investing aims at earning profits with an associated risk-return trade-off.
- Saving and investing are sequential; one must save before investing.
- Key Investment Evaluation Factors:
- Safety: Involves capital protection and certainty of income; understanding risks is vital.
- Liquidity: Measures ease of converting investments to cash; factors include lock-ins, penalties, and divisibility.
- Returns: Can be from periodic income or capital gains; exit charges affect returns.
- Convenience: Refers to ease of investing, redeeming, tracking, and receiving income.
- Ticket Size: Minimum investment varies; should align with needs, not just affordability.
- Taxability: Post-tax returns matter more than gross returns; linked to product features and holding period.
- Tax Deduction: Reduces net investment cost but may involve lock-in periods, affecting liquidity.
- Holistic Evaluation:
- No factor should be assessed in isolation; investor’s personal goals and situation must guide decisions.
Different Asset Classes :
- Asset Classes Overview:
Investments are categorized into four major asset classes—Real Estate, Commodities, Equity, and Fixed Income—each with subcategories. - Real Estate:
- Mostly bought for self-occupation, not investment.
- Traits: location-sensitive, illiquid, indivisible, high transaction/maintenance costs.
- Generates rental income and capital appreciation; available in physical and financial forms.
- Commodities:
- Commonly consumed (e.g., gold, silver, fuel, food); most aren’t suitable for investment due to perishability/storage issues.
- Gold and silver are popular investments; globally priced, non-income generating, purity concerns exist.
- Fixed Income:
- Includes bonds/debentures issued by governments, corporates, etc.
- Offers regular interest income; generally safer than equity but not risk-free.
- Capital gains possible through secondary market trading.
- Equity:
- Represents ownership in a company; high risk but potentially high returns over the long term.
- Income through dividends; values fluctuate based on company performance.
- Comparative Insights:
- Equity, real estate, and commodities involve ownership; fixed income involves lending.
- Only fixed income ensures predictable cash flows; others carry uncertainty.
- Assets can be domestic or international, exposing investors to currency risk.
Investment Risks :
- Inflation Risk: Inflation erodes the value of money over time. To maintain or grow purchasing power, investment returns must at least match inflation; otherwise, one suffers a negative real rate of return.
- Liquidity Risk: Some investments (e.g., fixed deposits, PPF, real estate) may not be easily converted to cash without penalties or delays, making them unsuitable for short-term needs.
- Credit Risk: This is the risk of default or delay in repayment by the issuer of bonds/debentures. It depends on the borrower’s financial health and integrity. Government bonds are typically considered the safest.
- Market & Price Risk: Securities can fluctuate due to broad market trends, industry-specific changes, or company-specific issues. Diversification helps reduce company-specific risks but not overall market risk.
- Interest Rate Risk: Bond prices are inversely related to interest rate changes. Longer-term bonds are more sensitive to rate shifts, leading to higher price volatility when interest rates fluctuate.
Risk Measure & Management Strategies :
- Risk is unavoidable, but it can be managed through various strategies.
- Avoidance: Skip investment products with risks you don’t understand, though this may mean missing potential gains.
- Speculative positioning: Invest based on anticipated market events (e.g., interest rate changes), which requires superior market knowledge and carries high risk—not suited for most investors.
- Diversification: Spreading investments across assets reduces the risk of total loss and is ideal for general investors.
- Risk measurement tools: Credit risk is assessed via credit ratings and spreads; return volatility is measured using variance, standard deviation, beta, and modified duration.
Behavioural Biases In Investment Decision Making
- Behavioral biases significantly impact investment decisions due to emotions like fear, greed, and hope.
- Availability Heuristic causes investors to rely on recent or easily recalled experiences, ignoring deeper research and risks.
- Confirmation Bias leads to seeking information that supports existing beliefs, overlooking contrary evidence and risks.
- Familiarity Bias results in preference for known investments, limiting diversification and opportunities.
- Herd Mentality pushes investors to follow the crowd, which may lead to poor decisions in financial markets.
- Loss Aversion makes people avoid risks even when opportunities are profitable, due to fear of losses.
- Overconfidence leads to underestimating risks and overestimating one’s decision-making ability.
- Recency Bias causes recent events to heavily influence decisions, often leading to overreaction.
- Personal behaviour patterns and financial personality (spender/saver/investor) affect investment habits.
- Investor interests and ethics can skew portfolio construction and discipline; ethical investors tend to make more prudent decisions.
- Professional advice from RIAs or MFDs can help mitigate emotional biases and improve decision-making.
Risk Profiling :
- Risk profiling assesses an investor’s risk appetite to ensure suitable mutual fund recommendations.
- It involves evaluating the need, ability, and willingness to take risks.
- Distributors must balance these three aspects, especially in case of conflict.
- Various methods exist for profiling; distributors may adopt existing ones or create their own.
Understanding Asset Allocation :
- Asset Allocation is the process of distributing an investor’s money across asset categories to meet specific financial objectives.
- It must follow a structured process and not be done randomly.
- Two main types of asset allocation approaches:
- Strategic Asset Allocation: Based on financial goals, time horizon, and risk profile; maintains a target allocation.
- Tactical Asset Allocation: Dynamic changes based on market conditions to improve risk-adjusted returns.
- Rebalancing is necessary when portfolio allocations deviate from targets due to market fluctuations or changes in investor profile.
- Rebalancing ensures “buy low, sell high” without active market timing and is applicable in both strategic and tactical allocations.
- SEBI mandates a 30-business-day rebalancing period (except for Index, ETF, and Overnight Funds) for deviations not caused by AMC actions.
DIY Vs Taking Professional Help :
- Investment Options: Investors can choose from various financial instruments such as government schemes, bank deposits, shares, real estate, and precious metals.
- Self vs. Professional Management: Investors can manage their investments themselves or outsource the task to professionals like mutual funds.
- What is a Mutual Fund?: It is a professionally managed investment option handled by an Asset Management Company (AMC), not a different investment class.
- Key Decision Factors:
- Ability: One must have the knowledge and time to manage investments effectively.
- Desire: Even with ability, one may prefer spending time on personal or professional pursuits.
- Affordability: Outsourcing involves fees, but self-management has hidden costs like time and errors.
- Hidden Costs of Self-Management:
- Time Value: Managing investments personally takes significant time, which could be costly.
- Emotional Bias: Self-managed portfolios are prone to mistakes due to emotional involvement.
- Conclusion: For most individuals, mutual funds offer a more effective and efficient way to manage investments.