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 naïve 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.”

Perspectives on Financial Planning

This post was triggered by a conversation I had with two people last week, both close to retirement.  The specific topic of our discussion was the management of finances after retirement.  My points were on the lines that I have mentioned in an earlier post but somewhere, I dropped the phrase, ‘financial planning.’  To this, one of them responded by saying something to the effect that he’d been doing fine without having to indulge in “Western concepts” such as financial planning.  When I tried to correct that impression, the other gentleman chipped in by saying that even if it wasn’t a “Western concept,” it was certainly a “new age concept,” most likely a “fad.”

Financial Planning is widely defined as “the process of meeting one’s life goals through the proper management of one’s finances.”  The term, ‘life goals,’ refers to events such as retirement, buying or building a house, the higher education of one’s children, or the marriage of one’s children.  Financial Planning requires us to ascertain how much money should be kept aside for these events.  It then involves aligning existing investments and investing future savings in a manner that maximizes the chances of having the required amount of  money when we need it.

Clearly, this description of Financial Planning would sound logical to anyone, anywhere across the globe.  Furthermore, in India, we have, for generations, been conscious of the need for financial security and have accepted it as our responsibility, to plan for our children’s future.  So what would explain the reaction of those gentlemen?

Their reaction was on account of their inability to link the phrase, ‘Financial Planning,’ to the concept of financial planning.  Even though the concept has been in practice in India for generations, we never gave it a name.  On the other hand, the phrase came to our wider attention only at the start of this century, but without any  linkage to the concept that we had already been practising.  To add confusion, there have emerged a set of advisors who, armed with a certification in financial planning, use the media to give the impression that good financial planning needs a sophisticated understanding, which investors (or even advisors without any certification) are incapable of possessing.

Financial planning is rooted in a recognition that investing is about more than just seeking high returns or the safety of our money.  The best investment decisions are those that are made in the context of our life goals.  The money that we save and invest, is best targeted at transforming our financial needs and aspirations into reality.  Whether we describe this as Financial Planning, or give it any other name, is immaterial. 

Many years ago, as I remember, the typical modus operandi for financial planning in a household would be to start by crudely estimating how much money would be needed for a future goal (such as a child’s marriage) and then figure out how much was needed to be saved based upon how long it would take for an amount to double in a bank deposit or a Post Office scheme.  All the families then had to do was to find the means and the discipline to invest that amount.  Distilled to its essence, success in financial planning has had a lot to do with the application of commonsense and financial discipline.

Yes, there are aspects related to the times that we live in,  that make the case for engaging a financial advisor.  In today’s times, most working people do not have the comfort of having an assured pension after retirement.  Furthermore, with progress in medical science enabling us to live longer, those of us retiring today are likely to spend more years in retirement than those who retired, say, twenty years ago.  In addition, there are many more things, small and big, that we would like to spend our money on.  The net result of all of this is that to achieve all our goals, a number of us will need to earn a return on our investments that is higher than what bank deposits offer.  In other words, a number of us would need to invest in complex options such as shares and mutual funds.  It is in respect to these investment options that a good financial advisor can add the most value by helping make choices that maximize the chances of us meeting our goals.  And to do that, in my opinion, a certification in financial planning is not a pre-requisite.

The temptation of direct plans

Every mutual fund scheme in India (with a few exceptions) is currently available in two broad variants (or ‘plans’)- one, on which advisors are paid commissions, and the other, on which they are not.  The second kind of plans are referred to as ‘direct plans.’  Direct plans are necessarily expected to have a lower expense ratio and a separate NAV.  All else being equal, the direct plan of a scheme can be expected to give a better return. 

To anyone who gets the mathematics of a direct plan, it can be a very alluring option. In the words of an investor whom I met, “It’s a no-brainer.”  Personally,  I believe that is important to understand and evaluate the downside before making a decision.  To do so, I recommend asking oneself one or two questions.

The first question to ask is: Do I really need a financial advisor?  To properly answer this question, it would help to list out what a financial advisor does, and what you would have to do if you did not have one (you may like to check out an earlier post on the role of an advisor).  If necessary, have a chat with your advisor(s).  If the answer is ‘no,’ then direct plans are a perfect option for you. 

If, on the other hand, the answer to that question is ‘yes,’ then the next question to ask is: Would I benefit from having an advisor who charges me a fee?  To clarify, while the overwhelming majority of financial advisors in India depend on the commissions they receive, there is an emerging breed of advisors that instead charge a fee from their clients for their advice.  These are often referred to as ‘fee-only advisors.’  If the answer is ‘yes,’ then direct plans are an obvious choice for you.  

In all fairness, though, the second question is not easy to answer, and would require you to reach out a few different fee-only advisors.  Assuming you can identify some advisors whom you can trust, you would need to know the services that would be provided and those that would not.  For instance, not all fee-only advisors have the ability to monitor a portfolio built around direct plans, and to provide performance and tax reports. At another level, you would need to analyze the cost benefit (i.e. comparing the fee with the benefit in costs from a direct plan).  

As I see it, direct plans do not represent a free lunch, just a discount.  Unless we can find a suitable fee-only advisor, these are best regarded as a self-service option.

What is the role of a financial advisor?

It’s a question a number of investors have asked, and continue to ask.  It’s a question which not many advisors answer well.  But it is an important question, especially in today’s scenario where investors have enough information and ease of execution to consider bypassing an advisor and investing directly. 

I believe that doing so may not be in the best interest of most investors, and that most of us would benefit from having a good advisor.  As a first step towards evaluating the appropriateness of an advisor, I think it is important to know what to expect of an advisor.  In this post, I propose to offer some thoughts on this.

While individual opinions across advisors and investors may not be exactly the same, in the context of mutual funds, I doubt if there will be any significant disagreement over the following expectations:

• Identifying suitable funds
• Determining the share of each fund in one’s portfolio
• Determining when to buy or sell a fund
• Facilitating buying and selling of funds
• Providing after-sales and ongoing service
• Performance analysis and reporting
• Tax planning

One could apply most of these expectations to any other investment product. 

As I see it, this is one way of looking at an advisor’s role.  Depending on how an advisor positions himself/ herself or depending on how an investor perceives the role of an advisor, there can be many more expectations added to this.  For instance, some advisors position themselves as capable of helping their clients define their life goals and drawing a roadmap towards achieving those goals.  There are some who position themselves, more ambitiously, as solution providers for all money matters.  In the words of one such advisor, “I am a banker, broker, lawyer, chartered accountant, and investment specialist, rolled into one.”

A few years ago, I came across an article titled, Role of an Investment Advisor, on the website of a US-based financial advisory firm, Black Walnut Advisors, LLC.  Here is an excerpt worth talking about in the context of this post:

The Role of Your Advisor

So with access to all of these specialists, some investors are unclear about the role their advisor plays. Some come right out and ask, “What does my advisor do for me?” Here’s the answer. Your investment advisor:

• Works with you to discover your personal financial objectives

• Assesses your entire financial situation (all major holdings including home equity, art, stock options, etc.)
• Designs a customized investment plan that offers a realistic opportunity to achieve your goals
• Screens the industry’s best service providers to identify those that offer services that complement your goals
• Works with those providers to implement your customized investment plan
• Monitors the providers and replaces them if they fail to meet your objectives
• Tracks the providers to be sure they don’t stray from the investment style they were hired to implement
• Monitors your portfolio and recommends adjustments to your strategy based on conditions in the capital markets, changes in your life and progress toward your goals
• Provides education and guidance to help you understand your investments and to keep your goals in sight and portfolio on track regardless of current market conditions
• Celebrates with you when things go well
• Feels your pain directly on the bottom line when times are tough

No discussion on the role of an advisor can be complete without a mention of noted industry observer, Meir Statman.  I find his writings on this subject extremely illuminating.  For this post, I would like to present an extract from his article, Financial Physicians, which was published in AIMR’s Investment Counseling for Private Clients IV, in August, 2002.

Financial advisors who act as financial physicians combine the science of finance and securities with the ability to empathize with and guide clients- thinking not about risk and return but about investors' fears, aspirations, and the errors they are likely to make. Financial advisors promote wealth and well-being just as physicians promote health and well-being.

As I suggested above, and as illustrated by these examples, there is no single way in which to look at the role of an advisor. Individual expectations can, and do vary.  For a meaningful advisor-client relationship (as for any relationship), it is important that there is a matching of expectations on all sides.

I would like to close this post with something I overheard from a passionate conversation between an investment advisor and his client: “My job is to protect you from yourself!”

Personally, I agree with that observation but I’ll leave any elaboration on this for a future post.

Looking for a good equity fund? Ask your advisor

Over the years, in conversations with people whom I met outside my work, I have often been asked to recommend a good equity fund to invest into. Once upon a time, I used to respond by whole-heartedly listing the funds that I believed to have the potential to deliver above-average returns over a period of 5 years or more. It would be an honest answer but the underlying assumption behind my response would be that it was an academic question, driven by the demands of polite conversation. Not for a moment did I think that any one of these people would ever act upon what I said. As it turned out, I was wrong.

I came to realize that a number of investors actually sought out funds to invest into, through random conversations with multiple investment professionals. More worryingly, I realized that a number of them did not have the temperament needed for successful equity investing. For instance, they exhibited the tendency to invest significantly during periods of mass euphoria and refrain from investing when prices were most attractive. Probably, worst of all, quite a few jeopardized their investment goals by not exiting these funds as their goals approached.

These observations triggered a few questions within me. What was the point of good returns if you didn’t get them when you needed them? What should an investor do to maximize the chances of meeting his/ her objectives? Could there really be a single fund that could help an investor do so?

I have, since, revised my response to anyone who asks me to recommend an equity fund. I present below the broad strokes of what I now say, and the beliefs supporting it.

Asking someone to recommend a good equity fund is somewhat like asking someone to recommend a good, strong medicine. Neither should be taken lightly. Medicines are best prescribed by a doctor who thoroughly understands the patient’s condition. Similarly, equity funds are best recommended by a trusted investment advisor who understands the investment objectives of the client and his/her psychological ability to handle market fluctuations, amongst other things. Done correctly, the chances are that the recommendation will have multiple funds, and will include equity and debt funds. Equity funds, on their own, have a clear limitation in their ability to protect downside risk. In 2008, for instance, the fall in the NAVs of a number of equity funds was so steep that it wiped out the gains accumulated over the preceding 2 years. Such a period of negative performance closer to the point when one needs to withdraw money could significantly, adversely impact the purpose for which the money is needed. In fact, more than the choice of individual funds, the quality of an advisor’s recommendation will hinge on the appropriateness of the mix of equity and debt funds at any given time, technically referred to, as ‘Asset Allocation.’ While it is not impossible for an investor to construct such a mix, it helps to have the expertise of a good financial advisor.

There are some hybrid funds that attempt to construct and adjust such a mix, based on market indicators. These are often referred to, as ‘Dynamic (or Tactical) Asset Allocation Funds’. In effect, these use this mix as a means to offer returns that are somewhat comparable to equity funds while attempting to minimize the risks associated with such funds.

These funds are not a substitute for the expert advice of a good financial advisor. Yes, some advisors do use these funds as part of their fund recommendations, but it is primarily through their understanding and execution of asset allocation that they add value for their clients, and not so much through the use of these funds. Nonetheless, in case you want to know more about these funds, the Value Research website offers a comparison that can be accessed here.

Do bear in mind, though, like any other fund, selecting the right Asset Allocation fund requires a thorough understanding of the investment objective and the strategy. Secondly, these funds come in two distinct variants: those that have an automated basis to the equity-debt mix and the adjustments to that, and those that rely on the fund manager to interpret the market indicators and determine the right mix and the subsequent adjustments. If in doubt, stick to the first type (better still, consult an advisor!) Lastly, there are very few of these funds, and fewer still that were actually around in 2008 and 2011 and can, thus, be analyzed for evidence of protecting the downside risk.