Are you ready for a mature approach to personal finance?

Published: April 4, 2019 at 10:10 am

Last Updated on

In this guest post, SEBI registered investment advisor Avinash Luthria who is part of my list of advisors and fee-only India discusses six simple and elegant approaches to managing money. Avinash previously was a Private Equity & Venture Capital investor. His articles have appeared at Business Standard, Mint and The Ken. I respect Avinash’s realistic views on investment risk and reward.

His previous articles at freefincal include:

If you wish to work with Avinash use the contact info at his website: Fiduciaries 

The mature approach to personal finance

E.g. Don’t fall for myths such as ‘equity is safe in the long-term’

There is so much of personal finance advice that goes around. And a lot of it is contradictory. But that does not mean that all approaches are equally good or bad. Some approaches are clearly better than others. It will take a long time to explain why a particular approach is better. To do that, one will have to go into the theory, the data, various principles and psychology. In general, the objective of any rational approach should be to improve the probability of survival. And to do that, instead of trying to maximize the upside, it makes more sense to try to minimize the downside. But talking about all that will get quite esoteric and we can do that some other time. Instead, let’s look at six approaches that make more sense. I have labelled this, ‘the mature approach’. And let’s leave the difficult example for the end and start with the easiest example of the mature approach.

Are you ready for a mature approach to personal finance?

1 Diversify

William Sharpe is a Nobel prize winner in Economics and one of the pioneers of modern personal finance. Those who follow a mature approach may not have heard of him, but they have gravitated towards following his golden rules of investing which are to diversify and keep investment costs low. Let’s look at each of these approaches.

There are many different forms of diversification that are important. Over here, let’s look at only one form. When the stock market has been doing well over a few years, many people increase their allocation to equity. For example, they may increase it to 80% of their net worth. Then later during a severe stock market crash, their net worth gets decimated. To protect what remains of their net worth, they then reduce their allocation to equity to say 0% of their net worth. Such wild swings in allocation are often harmful. This behaviour is so common that there is a term for the damage that it does. It is called the Behaviour Gap. Studies in the US have shown that such behaviour is reducing the average lay investors returns by 2% per annum. And that is a very large amount of money.

People who follow the mature approach accept that no one knows for sure how the stock market will do over even the next 10 years. Hence, they do not wildly vary their allocation to equity. Instead, they diversify.

2 Minimize investment costs

Most people think it is ok to pay high fees to a fund manager or distributor or SEBI registered Investment Adviser in the hope that they will do much better than the market. Followers of the mature approach know that matching the market return is all that one can hope for and one should be content with that. And paying high fees to try to beat the market will just damage your net worth.

Investors often waste 1% of their net worth each year by paying high fees to mutual fund managers and advisers. When cumulated over 30 years, simple arithmetic shows that such an investor would have lost 26% of his or her net worth. Mental math shows that they will lose close to 30% of their net worth. And any calculator will provide the exact number which is that they will lose 26% of their net worth.

3 Plan for zero real-returns

The assumptions that you make about investment returns have a profound impact on how much you have to save and when you can retire.

While thinking about returns, one should think in terms of real returns. Real returns are returns after subtracting inflation. Also, one has to think of post-tax returns. Further, what matters is the returns on the entire portfolio and not just the returns on equity investments. The entire portfolio also includes safe investments which have lower expected returns.

In my article ‘Living with Zero Real Returns’, I have argued one should assume a zero post-tax real-return over one’s lifetime. There are many nuances that this article could not cover. For example, as you get older and you get closer to your peak, real net worth, you will typically have to put a larger proportion of your net worth in safe investments which have lower expected returns. But let’s move on to two implications which are more important.

First, you will often come across statements like “saving 20 to 30% of your post-tax salary is sufficient to cover retirement plus higher education for children”. The mature approach shows that on the average over their lifetime, most people have to save in the ballpark of 50% of their post-tax salary.

Second, you will often come across statements like “if you put your mind to it, you can easily completely retire at the age of 40 or 45”. The mature approach recognizes that it is very difficult to do this. Hence, only a trivial number of people will be able to do this. Retiring too early may hurt you. So, in case you are no longer willing to do a high stress role, you may at least have to continue in a lower stress role.

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4 Stop chasing alpha and instead focus your attention on big picture questions including asset allocation

Alpha means outperforming the stock market. And almost all Do-It-Yourself investors and advisers completely focus on it. But chasing alpha is like betting or gambling and it is likely to hurt your net worth. This article elaborates on it: ‘Turn no-free-lunch from an opponent to an ally’ .

Even if chasing alpha does not hurt one’s net worth, at the very least it distracts us from more important issues and questions. The mature approach does not waste time on chasing alpha and instead focuses attention on more important questions. For example, given the stage in your career and your temperament for risk, what should your asset allocation be? Or, how will you mitigate the risk of living too long or the risk of unexpectedly high inflation?  Or, what should you do when there are no products to help mitigate certain important risks? I have covered a few of these aspects in my articles  ‘Three Financial Risks to Plan for Before Retiring – Some risks can’t be mitigated by products as such products almost don’t exist in India’ and ‘You can mitigate domestic risks by investing abroad, here’s how’.

5. Minimize mistakes

Many people think the way to be a good investor is to hit the ball out of the park. If any of us try to use this approach, we will increase the number of mistakes that we make. For example, we may make mistakes like investing in cryptocurrencies and structured products (Structured Products are covered in the second half of this article ’How even DIY investors can benefit from a registered investment advisor’.

The mature approach realizes that being a good investor is not about hitting the ball out of the park and instead requires that one minimize mistakes. These are a few ways to do this. For example, avoid exotic products. Instead, focus on simple products that you can understand, and which are more predictable. In a week or so, I will be publishing an article about a few ways to avoid investment mistakes and you could access that article via this link: fiduciaries.in/articles.

Even if we use the mature approach, we will still make some mistakes. But not trying to hit the ball out of the park, can minimize the number of mistakes that we make. And that is all that is within our control.

6. Don’t fall for myths such as ‘equity is safe in the long-term’

Most Do-It-Yourself investors and most advisors argue that equity is safe if you can hold the investment for 5 to 10 years. But this is a vague statement so we cannot test it. A more precise version of this statement is something like, if one holds equity for 5 to 10 years, than one can be sure that it will at least match inflation and, on the average, will generate higher returns than inflation.

The data and theory behind this statement is quite complex. For example, the theory requires you to read a lot of academic papers, including by Nobel Prize winners. For someone who cannot figure out the data and theory, they may be forced to think through the principles. In this case, this myth violates the principle of no free lunch. The principle of no free lunch says that one cannot get a higher return without making some sacrifice for it. But it will take time to explain why this myth violates this principle. Let’s not go on any of those tangents and let’s jump to the correct answer. The simplified correct answer is: Over say a 5 to 10-year horizon, there is a higher probability that equity will at least match inflation but there is also a material probability that it will generate returns that are lower than inflation.

Those who imagine that equity is guaranteed to be safe in the long-term are naturally willing to have very high equity allocations. For example, a 60-year-old who has 40 to 50 percent allocation to equity. People who follow the mature approach are sceptical about the optimistic arguments and hence they usually have a lower allocation to equity. For example, at the same age of 60, an equity allocation of 20 to 25 percent (this article provides an illustration)  ‘Are you taking too much equity risk? — Decide equity allocation based on your need, capacity and temperament for risk’ .

The six approaches that we have discussed are just a subset out of a wider set of such points. There are always other aspects and further levels that one has to think about.

Avoiding the non-mature approach

There are many reasons why the wealth management industry uses the non-mature approach. One reason is that most people in the wealth management industry, are just salesmen who don’t know any better. This includes the CEOs and other senior management of wealth management companies who offer advice through articles in the press and TV appearances. The second reason that they use optimistic arguments is because such arguments are a very effective form of selling. Optimistic arguments make the client feel good about their future. This then puts the client in a frame of mind in which they are willing to buy complex products or services that have high sales commissions or high fees.

So, a good starting point to gravitate towards the mature approach is to be sceptical about all such arguments that sound good or make you feel good. Being sceptical is the starting point.  The hard work to understand reality starts after that.

As a summary, lets focus on the two most useful lines — Diversify and keep investment costs low. And plan for zero real-returns.

Video Version

Avinash Luthria is Founder, Fee-Only Financial Planner & SEBI registered Investment Adviser at Fiduciaries  and was previously a Private Equity & Venture Capital investor for 12 years; Views expressed here are of the author and do not necessarily reflect the views of freefincal.

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Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.
He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com

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3 Comments

  1. Excellent article with well argued points. Hope the more discerning investor gets these key points… and is judicious in his final asset allocation. Sadly 30 times annual expenses is out of reach for many.
    I would be interested in knowing Avinash’s views on the bucket approach to overcome some behavioural issues since invariably retirees opt for FDs, sometimes with just 10 or 15 times their expenses.

    1. Ram,
      I am not sure that I have correctly understood your question about ‘Bucket Strategies’ but this is a partial reply. Jim Otar has provided an intuitive answer in this article, in the section ‘A simpler explanation’ on page 14 where he uses dividing a pizza an example. Please read only the first 6 paragraphs of that section (i.e. only till “…This is not always true.”) because I do not agree with some of the paragraphs after that. Some aspects / nuances of my view’s are slightly different from Jim Otar’s views but I think his intuitive answer on this topic is far better than anything I can think of to communicate this point. The article does not allow one to copy paste the relevant text and the images in the article help to communicate his point:
      ’10 Bucket Strategies That Don’t Work’ by Jim Otar
      http://www.retirementoptimizer.com/articles/Bucket%20Strategies%20That%20Don't%20Work.pdf

  2. “Being sceptical is the starting point. The hard work to understand reality starts after that.”

    This explains my journey as a DIY investor of 3 years. I could not calculate the returns from a complex financial product I was sold to save tax. I could not understand what NPS means and why this website was so against that product. This kicked off a skepticism and after that its been a series of bitter pills, but yeah.. such is life.

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