Life and Investing

Beyond the often-cited need for returns or safety of our money, there is a bigger purpose to investing in our lives.  The clarity to see investing in the context of life can help us make better investment decisions.  This post offers a perspective on this for those of us who are working and haven’t yet retired.

Most of us start our working lives with no wealth, dependent on the earnings from our profession.  As we move through life, most of us build wealth through what we save from the earnings from our profession, and invest.  Years later, when we retire from our profession or choose to take things easy, the wealth that we have built by then, will likely be the primary source of our income. 

Even so, some of us will retire out of necessity (brought about by age or an inability to earn income from our profession), while some of us will do so out of choice, on our own terms.  Whether we will, indeed, be able to be live life on our own terms, will depend on the amount of wealth we are able to acquire, relative to our need for passively generating income from it. If asked to choose between retiring out of necessity and retiring on our own terms, each one of us would prefer the latter. Logically, therefore, the acquisition of the wealth to be able to do so, should be an important (if not the most important) purpose for investing.

Equally logically, we need to understand what it would take to accomplish this goal.  No doubt, the quality of the investment choices that we make throughout our life will contribute to the wealth we build.  In addition, I’d like to submit two factors, related to investing, that will also play a crucial role: one, the amount that we save and invest, and the other, the timeliness of our investments (i.e. our ability to not delay investing).

In my experience, far too many of us focus our attention on the quality of investment choices, losing sight of these two factors.  While all three work best together, and not in isolation of each other, I believe there is a case to say that these two factors are individually more important than quality of our investment choices.  I hope to touch upon this in more detail in a future post.  For now, I’d like to offer the following thoughts:

For a number of people, savings are regarded as what is left over from one’s income, after factoring expenses.  In other words, for such people, paying for today’s expenses is more important than planning for future expenses.  I recommend flipping this around.  I believe that the wealth that we need to meet our future aspirations should determine our investment choices and the amount that we save, and not vice versa.  So long as our aspirations are reasonable, and we start investing early in life, it shouldn’t be difficult to find the right balance between our savings and our expenses.  Thrift and regular investing can also reduce the need for riskier investments, so to say.

While deciding our investment choices, we should diversify against the risk of our profession.  This risk is highest for employees having significant holdings of shares of the company they work for, or entrepreneurs keeping most of their wealth as capital in their business.  What if, something were to happen to the company one works for?  What if, something were to happen to one's business?  Limiting one’s exposure to one's business or the shares of the company that one works for, helps protect against this risk.

Looking at investing in the context of life is a key part of what is known as, ‘financial planning.’  Financial planners understand their client’s financial aspirations and then draw up a roadmap to translate these into reality.  Most even handhold the client on the way towards achieving these aspirations.  Chances are that your trusted financial advisor would be adept in the art and arithmetic of financial planning.  If not, you might like to ask around or check out the website of the Financial Planning Standards Board India.  They have the option to search through the list of financial planners registered with them.

Diversification

Diversification is the strategy of spreading one’s money across multiple investment options. In its simplest form, it involves dividing one’s money across as many different kinds of investments as possible; in its more sophisticated form, it involves assessing which investment categories to have one’s money into, and to what extent (also referred to, as ‘asset allocation’).  Diversification makes one’s portfolio less dependent on the performance of a single investment or category of investments.  It can also minimize the impact of unpleasant surprises that may affect any single investment or category of investments.

In my opinion, the single most important reason to invest in mutual funds is the speed and convenience with which an individual can actually build a diversified mix of investments. In this post, I would like to share my thoughts on some questions related to diversification that I am often asked.

“If I invest in a safe place such as a PPF or a bank deposit, do I still need to diversify my investments?”

For a number of people, the term, ‘risk,’ implies the potential loss of capital, and ‘safe’ investments are those that implicitly or explicitly guarantee against that. Fact is, risks come in a variety of forms, and all investments, including those that we might consider as ‘safe,’ carry some kind of risk. For instance, most ‘safe’ investments carry the risk of not beating inflation.  By diversifying across investment categories, we can use the strengths of  one investment category to offset the risks of another.  To illustrate, equity investments can offset the risk of not beating inflation, that debt instruments carry.  Debt instruments, in turn, provide a cushion against the risk of price fluctuations, that equity investments carry.

Additionally, there are some risks that could affect any investment or investment category but may not necessarily impact all investments or investment categories at the same time.  For instance, there is the risk of an unexpected and inconvenient delay in getting back one’s money. (Just in case you find this difficult to relate to, you might like to visit online consumer grievance sites and check out the complaints related to withdrawal of investments, including those made with government-owned institutions.)  Diversification helps minimize the impact of such a risk.

“Is there any point to diversifying across multiple equity funds if they all hold shares of the same or similar companies in their portfolios?”

True, our gains from a fund are linked to the gains from the underlying investments. More specifically, other than in index funds, our gains are linked to the gains that the fund manager derives from the underlying investments. Two funds may have the shares of the same companies in their portfolios, yet the specific reasons for the respective fund managers to hold these could be very different. These fund managers may have different price targets to accumulate, and different price targets to sell.

Thus, there is merit in diversifying across funds with similar portfolios if the fund managers are different, and they employ different strategies.

“Wouldn’t an equal diversification across multiple equity funds result in average returns?”

While an equal diversification will result in average returns relative to other equity funds, my experience, and the evidence that I have examined, lead me to believe that it is likely to result in above-average returns relative to other investors.  Let me explain.

As suggested in an earlier post, I believe it is difficult, if not impossible, to know which funds will do well, relative to others.  Yet, as I also hinted, our brains are wired in such a way that most of us cannot resist the impulse to predict winners, so to say, and invest in them.  Once we do so, a number of us try to improve the odds by frequently switching funds.  This adds costs and usually reduces returns.  Last, but not the least, when prices fall, a number of us panic and get out and stay out, and miss the inevitable rise in prices, as and when that happens.  All of this results in returns that, more often than not, are less than what could have been achieved by simple diversification.  My analysis also suggests that if one were to do a basic, qualitative screening of the funds to diversify across, the results would be far more in favor of diversification.