April 12, 2015

Know Your Enemies

The road to investing success can be likened to a battlefield.  There are people and entities out there, who want a share of our money, and may stop at nothing to get that.  There are also other obstacles that, if not overcome, can harm our aspirations, and even leave us financially crippled.  These people and obstacles are the enemies that I allude to.  What makes things tough is that some of these people give the impression of being friends, not foes, and that some of the obstacles are simply hidden from plain sight. This post is intended to put a spotlight on a few of these enemies.

Taxes and Inflation

There is a quote of unclear origin that goes thus: “The way to crush the bourgeoisie is to grind them down between the millstones of taxation and inflation.”  The author may as well been talking about investors.  Consider this: if the rate of inflation were to be 8%, for someone paying 30% as taxes, to merely break-even against the combined impact of taxes and inflation, he/she would have to earn a return of 11.43% p.a. on his/her investments.  To see any growth in the true value of his/her money, such an investor would have to earn a return greater than that.

Of the two, inflation is the bigger threat.  It is inescapable, and carries a greater impact.  For example, on an investment return of 9% p.a. over a period of 10 years, having to deal with an inflation rate of 8% p.a. is equivalent to paying taxes each year at the rate of almost 90%. Inflation is also more stealthy: taxes are mostly visible as we pay them, year after year, whereas inflation creeps up on us from behind and eats into our purchasing power. 

Equity funds can help fight inflation.  These are also highly tax-efficient.  Opting for debt funds over bank deposits (or most other debt instruments) can bring down one’s taxes, provided one is willing to hold these for over 3 years.  Amongst debt funds, open-end schemes carry one significant advantage over closed-end schemes: one can defer one’s taxes as long as one wants to.  Obviously, selecting the right equity and debt funds is important. Knowing how much of each to have in one’s portfolio (i.e. the asset allocation) is crucial.

The Financial Services Industry

In his investment classic, ‘The Four Pillars of Investing,’ William Bernstein had this to say about the financial services industry:

“Investors tend to be touchingly na├»ve about stockbrokers and mutual fund companies: brokers are not your friends, and the interests of the fund companies are highly divergent from yours. You are in fact locked in a financial life-and-death struggle with the investment industry; losing that battle puts you at increased risk of running short of assets far sooner than you’d like. The more you know about the industry’s priorities and how it operates, the more likely it is that you will be able to thwart it.”

In the introduction to this blog I referred to the noble purpose that the mutual fund industry serves.  Yet, as I have pointed out (for instance, here), many, if not most, fund houses have indulged in dubious practices.  Worse, there has been a tacit collusion between some unscrupulous fund houses and their distributors to legally make money off investors in a manner that raises questions of ethics and morality. 

Just to be clear, their intentions of ill-will should not make us stay away from investing in mutual fund schemes.  The reasons for investing remain as compelling as ever.  It is important that while doing so, we be aware of this and take adequate precautions to protect our interests.  Gathering information and perspectives is a vital part of being prepared to deal with these enemies.  As you do so, be sure to distinguish facts from opinions.  Verify facts, if necessary.  Question the opinions till you feel satisfied.  In addition, as I suggested in this post, ask questions of those whom you engage with: advisors, representatives of fund houses, or anyone else.  Trust only those whose integrity you feel comfortable about, and whose competence you see little basis to doubt.

The Person in the Mirror

Yes, you read that right.  According to Benjamin Graham, regarded by many as one of the greatest minds in investing, “the investor’s chief problem—and even his worst enemy—is likely to be himself.”  In case this makes you wonder, there is a large body of evidence that illustrates that most of us make flawed investment decisions.  Research also shows that our natural behavior leads most of us to be poor investors.   To put it in the quaint prose of William Bernstein: “Most of what we fondly call ‘human nature’ becomes a deadly quicksand of maladaptive behavior when allowed to roam free in the investment arena.” 

Our awareness of this fact, while an important step, still leaves us with significant challenges.  If we are fortunate to have access to the services of a good financial advisor whom we can trust, then we may have far less to worry about. Good financial advisors not only steer their clients clear of the pitfalls of their flaws, they also act as a behavioral coach.  Of course, good financial advisors are few and far between.

For most of us who don’t have access to a good financial advisor, it will be an uphill task correcting our flaws on our own.  A good starting point would be to acquire knowledge about the nature of these flaws.  There is one resource, in particular, that I would like to recommend in this regard.  This is a series of videos that were aired on the program, ‘Nightly Business Report’ on PBS in the US over 2009-10, under the title: ‘Your Mind and Your Money.’  Most, if not all, of the episodes have been uploaded on YouTube, and can be accessed by searching on the PBS channel.

To sum up, the enemies listed here may not be adversaries in any traditional sense but we would do well to treat them as such.  To quote Gerald Loeb in his book, ‘The Battle for Investment Survival’: “Your best weapons against the forces that tend to clip your fortune are knowledge and experience.”

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