FINANCIAL BEHAVIOR OF A RETAIL INVESTOR

When we talk of an investor, we relate him to only money and finances and tend to overlook the fact that first, he is a human being and thereafter an investor. Investor behaviour is characterized by his feelings, moods and sentiments, personality traits, perception, attitude and emotions. Therefore, like all other humans, his actions and decisions are affected by various biases. Investor psychology (the science dealing with the mind and mental processes, especially in relation to investor behaviour) classifies these into heuristic biases and cognitive biases. Simply put, a heuristic is a ‘Rule of Thumb’ mental shortcut used to solve a problem. It is a quick, informal, and intuitive algorithm that the brain uses to generate an approximate answer to a reasoning question. When investor heuristics fail to produce a correct judgment, it can sometimes result in a cognitive bias, wherein the processes information by filtering it through his experience, thoughts, likes, and dislikes. Psychologically, these biases lead an investor to a judgmental error when it comes to investing, which includes both buying and selling of the financial instruments. In this article, we will explain how some of these or other biases play up to influence the investor’s decision making. Some of these biases are listed in the chart below, and explained and exemplified through Mr Anil, a retail investor residing in a Tier II city of India, in the succeeding paragraphs. He represents the common salaried man who has two children and strives to make his ends meet within his salary.

Present Bias:  This is the tendency to overvalue immediate rewards at the expense of long-term goals. This bias propels Anil to live in the present without thinking too much about how the future unfolds. This gives rise to the tendency of overspending or anticipating a future windfall, which creates barriers to current saving and hampers long-term investment. Therefore, he indulges in buying consumer durables and enjoying lavish vacations and parties and postpones saving for his retirement to a later date. This proves disastrous in the long run since Anil does not start investing early. Thereby, he loses the advantage of the exponential growth of his early investment into a sizeable retirement corpus achieved through the power of compounding, which requires time.

Representativeness: This refers to the tendency to form judgements based on stereotypes. For example, you may form an opinion that a person is rich if you see him alighting from a luxury car, even when he does not own it but has merely travelled in it as a guest of the owner. This results in investors labelling an investment as good or bad based on its recent performance. As per Chandra Prasanna (2016), Behavioral Finance, McGraw Hill Education, investors may be drawn to mutual funds with a good track record because such funds are believed to be representative of well-performing funds. They may forget that even unskilled managers can earn high returns by chance. Investors may become overly optimistic about past winners and overly pessimistic about past losers. Investors generally assume that good companies are good stocks, although the opposite holds true most of the time. Consequently, Anil may buy stocks after prices have risen expecting those increases to continue and ignore stocks when their prices are below their intrinsic values.

Availability Bias: It is a bias where most relevant, recent, or traumatic events strongly influence the perceptions of investors that may be far from economic reality. The danger of basing investment decisions on market perception, rather than facts, is that Anil may pull his money out at the wrong time and miss some of the best days as the market recovers. In the stock trading area, this bias manifests itself for Anil through his preference to invest in local companies, which he is familiar with or about which he can easily obtain information, rather than relying on deeper market research.

Anchoring: It is the tendency to hold on to a belief and then apply it as a subjective reference point for making future judgments. Anchoring occurs when an individual lets a specific piece of information control his cognitive decision-making process. As per Chandra Prasanna (2016), Behavioral Finance, McGraw Hill Education, there are two plausible explanations for anchoring. The first is based on uncertainty relating to true value. When there is uncertainty, the decision maker adjusts his answer away from anchoring value until he enters a plausible range. This explanation works best for relevant anchors.  The second explanation is based on cognitive laziness. Since it requires effort to move away from the anchor and people are cognitively lazy, they tend to stop too early. This explanation works best for irrelevant anchors. Therefore, anchoring will lead Anil to invest in the stocks of companies that have dropped considerably over a short span of time. He is likely anchoring on a recent high point for the stock’s value, likely believing in some way that the fall in price suggests that there is an opportunity to buy the stock at a discounted rate. As far as Anil is concerned, the overall market has caused some stocks to drop significantly in value, thereby allowing him to capitalize on short-term volatility. However, what is perhaps more likely is that a stock which has dropped in value in this way has seen a change in its underlying fundamentals.

Regret or Loss Aversion: This refers to an important concept encapsulated in the expression “losses loom larger than gains” as the pain of losing is psychologically about twice as powerful as the pleasure of gaining. Typically, this is noticeable in the game of golf where the golfer avoids a water hazard by going around it or taking a layup shot. In the bargain, he loses a stroke or is required to play an excellent shot thereafter to make up the loss. Similarly, Anil will prefer to avoid the loss because the associated pain is more intense than the reward that he will feel from a gain. To avoid this pain of loss, he will try to play safe and resultantly move his investments to a place he perceives as safe-haven i.e. cash, cash equivalents or fixed income instruments. Another step he may undertake is to discontinue his ongoing SIP/SEP. All this will cost him when the inflation eats into his savings and erodes his purchasing power. Regret aversion can explain investor reluctance to sell losing investments because it gives them feedback that they have made bad decisions. Anticipated regret influences Anil’s decision making to take less risk because this lessens the potential of poor outcomes.

Overconfidence: This bias leads to the false assumption that someone is better than others, due to their own false sense of skill, talent, or self-belief. Investors often exhibit overconfident behaviour resulting in severe consequences. Research documents that overconfident behaviour is connected to excessive trading and results in poor investment returns. It can also lead to investors failing to appropriately diversify their portfolios. Overconfidence plays out in the real world and creates biases, viz. over ranking, illusion of control, desirability effect and timing optimism. Therefore, Anil having performed well in recent past may conclude that he is truly skilled and take more risks and trade more. To him his overconfidence will make future trades look less risky, but, when things go wrong his potential losses will be higher as they are directly proportional to his degree of overconfidence. Barber and Odean (2001) studied the role of trading behaviour and gender bias for a sample of 35,000 individual accounts over a six-year period. Their findings reveal that males are not only more overconfident about their investing abilities but also trade more often than females. Compared to women, men also tend to sell their stocks at the incorrect time resulting in higher trading costs. Women generally trade less and apply a “buy and hold” approach resulting in lower trading costs. Other studies have found that the relatively young are more overconfident than the relatively old and that highly overconfident people tend to have a higher risk tolerance.

mutual funds in jaipur
mutual funds in jaipur

Herd Effect: It happens when people feel most comfortable following the crowd and tend to assume the consensus view to be the correct one. It is also referred to as the bandwagon effect where the phenomenon of a popular trend attracts even greater popularity. This is the single most important bias in financial markets that create economic bubbles, which burst later to erode capital of the investors. History is replete with example of such bubbles, where during the run-up, investors bid up the prices to unsustainable levels. Then, even more quickly than they expanded, these markets burst and contracted to leave the herd scrambling. It is because of this bias that Anil will invest into a scrip or financial instrument that forms part of the rising bubble without due diligence and personal research, only to lose his capital when the bubble bursts.

INVESTMENT NUANCES

An investor is someone who commits capital in order to gain financial returns. Warren Buffett, the investment legend, defines investing as “… the process of laying out money now to receive more money in the future.”  An investor differs from a trader. An investor puts capital to use for long-term gain, while a trader seeks to generate short-term profits by buying and selling securities repeatedly. Therefore, the frequently asked question is whether investment is an art or science? Investment is neither an art or nor science; instead it is common sense based on three important tenets – discipline, patience, and knowledge. An investor must be wary of the market cycle and understand that when he invests, for all the gains that he will make, he will also incur some losses. It is impossible to only gain from the markets and not undergo some loss. However, a seasoned investor will mitigate his losses and increase his gains to ultimately improve his financial position. In this article we discuss some important facets that an investor must consider while he undertakes his investment journey.

Know
Yourself

There are no set piece solutions for investing or template that fits many or
all investors. Each investor is different and before you embark on your
investment journey, make sure that you know and understand yourself as an
investor. There are some important financial aspects that you must understand
and then devise your investment strategy. If you are unable to do it yourself,
then seek help from a financial advisor who can help you to do it. First, is to
establish your cash flow. If you are a salaried person then financial planning
is relatively easier due to fixed cash flow. For a businessperson, it is
trickier due to cash flow and business cycle uncertainties. Second, is setting
your life’s financial goals that include children education and marriage, house
purchase, retirement, dream vacations, and consumer durable among others. In so
doing, also decide on the time horizon for each of these goals to then classify
them into short, medium, and long-term financial goals. Third, is the aspect of
your risk-taking ability that is function of your age, cash flow and liabilities?
This will help you to decide whether you are an aggressive, moderate, or
conservative investor. Fourth, beware of venturing into investment options that
you do not understand merely because your friend does it or your advisor has
asked your to do it for higher returns. Invest only in what you understand and
are comfortable to deal. Fifth, invest in yourself and purchase health/life
insurance early in life to keep the premiums low. Normally, one should consider
separate family floater policy for health and critical illness coverage and a
term insurance policy for life coverage. Ideally, your life coverage should be
10 times of your annual salary.

Compounding – Einstein called “compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t pays it.” Compounding is the process of generating more return on an asset’s reinvested earnings. To work, it requires two things: the reinvestment of earnings and time. See the chart below where we have calculated the yearly compounding of rupees 1 lakh that earns 12 percent annual interest. In 30 years, it has grown to almost rupees 30 lakh. However, it has taken nearly 7 years to double and 21 years to grow 10 times. Thereafter, in the next 10 years it grew from 10 to nearly 30 times of the initial investment. As is evident, the exponential growth of the investment is only in the latter half of the investment period when the investment has grown from nearly 5 to 30 times. Therefore, the investor must start investing early to give himself adequate time for the compounding to work and minimise withdrawals or keep reinvesting the returns.

Real
Returns

understanding that real returns are the gains made after offsetting the
inflation and taxation will help an investor to consider and invest for maximum
total returns. Inflation erodes the purchasing power of money e.g. in 30 years,
real value of rupees 100 will become rupees 11.34 at 7 percent annual
inflation. The real rate of return is the return adjusted for inflation or
other factors. Adjusting the rate of return offers a better measure of
investment performance and allows for a more effective risk versus reward
measurement. Nominal rates are usually always higher than the real rate of
return. Even though fixed deposits guarantee returns, after tax and inflation
deduction, the real rate of returns in these varies between 0.45 to 0.75
percent. Investing in equities is one of the ways to beat inflation as they
generate positive real returns over long-term.

Flexibility – an investor must always remain
flexible in his investments by investing in different types of investments and
maintaining cash reserve to take care of emergencies (emergency fund) or take
advantage of investment opportunities. There are many types of investments like
mutual funds (open and close ended), ETFs, individual stocks and bonds, real estate,
and various alternative investments. An investor becomes a shareholder or part
owner by buying the company shares in dematerialized (Demat) form and thus
participates in the company’s growth/decline through rise/fall in share prices.
Besides, you also earn dividends that the company gives to its shareholders.
Before buying shares, the investor must use his power of observation, artful
questioning, and logical deduction to decide on the company. If the investor
buys company bonds, then he is loaning money to the company in exchange for
periodic interest payments plus the return of the bond’s face amount when the
bond matures. Both government and companies issue bonds. Several agencies issue
ratings to these bonds to evaluate the probability of whether a bond issuer
will default. Some of the important rating agencies are Standard and Poor
(S&P), Moody’s, CRISIL, ICRA and CARE. The investor should buy higher rated
bonds, which means the company has less chances of default. Government bonds
come with the sovereign guarantee and are relatively risk-free. Mutual fund
investment is best suited for passive investor who cannot actively track the
market or keep themselves abreast on a day to day basis. These are pooled
investments managed by professional fund managers that allow investors to
invest their money in stocks, bonds or other investment vehicles as stated in
the fund’s prospectus. Mutual funds use the end of trading day Net Asset Value
(NAV) for valuation and make distributions in the form of dividends and capital
gains based on this. They offer you the advantages of professional management,
high liquidity, and more tax efficient returns. Unlike mutual funds, ETFs
(although like mutual funds in many respects) trade constantly, like shares and
stocks, while the markets are open.

Diversification – to diversify means that the
investor must invest in various asset classes to manage his risk and earn
higher returns. This happens because the positive performance of some
investments neutralizes the negative performance of others. After, diversifying
his portfolio into various asset classes like equity, debt, gold, real estate
and fixed income instruments, the investor must also consider diversifying
within some of the these individually. He can consider buying securities of
large, mid, and small market cap companies or let us say mutual funds of
different asset management companies or different fixed income instruments like
PPF, FDs or SCSS and so on.

Keeping
Track
– after
investing, it is equally important to keep a track of your investments.
Ideally, you should review your portfolio on a half-yearly basis and if this is
asking too much then at least once a year is necessary. The portfolio review
will indicate the gainers and losers in the portfolio, the financial instrument’s
performance in relation to its financial goal and the overall growth of the
portfolio. Having reviewed the portfolio, the investor must then rebalance his
portfolio. In so doing, he must shed his losers, switch, or reinvest in other
asset classes to maximise gains and offset losses, and realign his portfolio
with his financial goals.

Technology – like all other facets of life,
technological advancement also has a significant impact on investors. The
digitization of the bourses and concomitant dematerialization of securities has
eased the investment avenues for investors. It has facilitated research and
analysis by investors by opening the plethora of information and tutorials on
the net, generated options for them to invest in various financial instruments
and significantly reduced paperwork by facilitating investment through the
click of a button. The next big change is the introduction of robo-advisory
services, which use technology for client portfolio management by using
algorithms. All these have eased out investor apprehensions and reduced tariffs
and fees.

Emotions – there is no place for emotions in
investments. An investor should be aware of the fear of loss or regret, greed,
risk aversion and bandwagon effect during his investment. An investor should
hold his stocks or other investments dispassionately and consider their
purchase or sale objectively. He should shed them when they have delivered the
result, stopped giving profit or outlived their utility. One cannot make an
investment for indefinite period; relate it to a financial goal or investment
horizon. Prudent investment is to the use financial assets that are suitable
for your financial goals and objectives by considering the risk/return profile
and the available time horizon. To do this, you must keep the fees and taxation
minimized, and rebalance the portfolio periodically.

Understanding
Markets
– know
that markets are volatile in the short-term. As the investment horizon
increases, probability of loss reduces. Sensex movement in the last 39 years
has proved that the likelihood of losing money for periods of 15 years or more
has been zero. Since 1979 till date, markets have given a CAGR of 17.1%. If
wealth compounds at this rate, then an investment in the stock market doubles
every 4.5 years. Robert Kiyosaki had suggested, “it is not how much money you
make, but how much money you keep, how hard it works for you, and how many
generations you keep it for.” If an investor stays fully invested in the market
then he will earn a lucrative CAGR that beats volatility and inflation.
However, if he tries to time the market, then he runs the risk of missing days
that registered some of the biggest gains and the CAGR will drop drastically.

Discipline – a disciplined approach in
investment by taking the SIP/SEP route help you to beat the market volatility,
achieve rupee cost average and reach your financial goal faster. Since the
early bird catches the worm, prudence lies in starting as early in life as
possible. Elders can inculcate the habit in their children by making them save
small amounts from their pocket money that they give them during school or
college days. Let us exemplify this with the case of two investors – Mr. Wise
and Mr. Unwise. Both investors invest rupees 36 lakh over different time spans
of their life. Mr. Wise invests rupees 10,000/- per month from the age of 25 to
55 years, whereas Mr. Unwise invests rupees 15,000 per month from 35 to 55
years. At the end of their investment period, Mr. Wise’s investment grows to
rupees 7.01 crore, but that of Mr. Unwise grows to only rupees 2.27 crore – a
shortfall of rupees 4.74 crore. There is no dearth of financial calculators or
ready reckoners, available on the internet, which show the exponential growth
of your wealth through the SIP route. Another aspect that an investor must
consider is to increase the SIP amount by 10 or 15 percent every year. Evident
from the table below is the fact that if an investor tops up or increases his
SIP of rupees 10,000 by 10 percent every year, then his corpus at the end of 30
years will be 150 percent more.

Details
SIP
without Annual Increase
SIP
with Annual Increase
Per
month SIP amount
Rupees 10
thousand
Rupees 10
thousand
Rate
of return
12% 12%
Investment
period
30 years 30 years
Total
amount invested
Rupees 36
lakh
Rupees
1.97 crore
Corpus
after 30 years
Rupees
3.53 crore
Rupees
8.83 crore

Taxation – since taxation is a dynamic
process and undergoes changes frequently an investor must keep himself abreast
with the taxation policy of his country. This will help him to invest in tax
efficient financial instruments that will also assist in simultaneous wealth
creation. In our country, government levies tax on your income through stipulated
income tax slabs. Government considers your annual interest income from various
fixed income instruments as part of your income and taxes them as per your IT
slab. Additionally, it also levies varying capital gains tax on your equity and
debt instruments and taxes them based on you holding duration (short-term if
you hold equity for less than one year and debt for less than 3 years, and
long-term if you hold both for periods more than their short-term duration
respectively). Capital gains harvesting or setting off capital losses are some
of the means to reduce taxation legally, provided you reinvest the capital to
maintain the corpus. Equity Linked Savings Scheme (ELSS) investment in mutual
funds with a 3-year lock-in period, provides lowest lock-in period and tax
efficient returns with tax savings under Sec 80C of the IT Act.

MONEY LESSONS FROM GOLF

As a game, golf is slow and boring to watch; yet it is addictive to play. This is probably the reason for its limited fan following as compared to more adrenaline pumping games like football or basketball. Unlike other games, where you try to beat an opponent at every stage, in golf you play against yourself – in other words, concentrate on your own game. This is because there is no concept of defense against the shot of your opponent. Ultimately, what matters is how well and near perfectly (perfection being nearly impossible to achieve in golf) you hit your shots to win the game. However, quality and dispassionate coaching play a crucial role in success in competitive golf.

Lesson: Learn to read and understand the market yourself and do not try to copy other investors. A financial advisor’s truthful and unbiased advice is of the essence to make sound financial decisions. Nevertheless, remember that it is your money and you are the best judge to take the final call.

A round of golf consists of 18 holes and a tournament can run over three to five such rounds. The tournament result counts the cumulative performance of the player spread across all these rounds and an inconsistent player may have one or two fabulous rounds but is unlikely to maintain the tempo through all the rounds. Therefore, a consistent player normally emerges the winner.

Lesson: Consistency in investment pays in the end. Invest through systematic investment plan (SIP) in mutual funds, systematic equity plan (SEP) in direct equity or recurring deposits in fixed income instruments.

Most professional players start at an early age and build up their game over years of dedicated practice. Starting early in life affords them certain distinct advantages of suppleness of body to develop a correct swing, availability of long hours of practice due to lesser responsibilities in life, and longer time horizon to understand competitive golf, learn to tackle its stresses and absorb its ups and downs.

Lesson: Start investing early in life for wealth creation. It provides you with a longer period for investment and to understand the markets, which in turn helps you to offset the market volatility. By starting early, you learn to stay calm and invest during the intimidating falling markets and book profits during the rewarding rising markets.

Professional golfers play scratch or below par, i.e. complete a round of 18 holes in 72 strokes (Par 72) or less. In amateur golf, handicapping is a numerical measure that indicates the number of additional strokes, over and above par 72, which the player will take to complete the round. Therefore, a better player has a lower handicap number and the weaker player has a higher number, e.g. an 8-handicapper is better than a 14-handicapper. Therefore, handicap creates a level playing field for all participants by giving the advantage of additional strokes to weaker players. He applies the handicap while calculating the scores as per varying formats of the game, viz. Match play, stroke play or stable ford.

Lesson: Know your handicap in money matters and apply them as per the varying situations. A person acknowledging his handicap of poor knowledge of direct equity investments then adopts the mutual fund route.

The amazing aspect of golf is that a 300-yard drive or a one-foot putt equal as one stroke on the scorecard. In fact, the short game (played on or within 50 yards of the green) contributes more to your success than the long drives since it comprises more than 60 % of the game.

Lesson: You must understand the contribution of each of your asset towards meeting your financial goals. If equity giving 12 % return comprises only 20 % of your wealth, then fixed income instruments giving 8 % return but forming 60 % of your portfolio will contribute more towards your financial well-being. See the table below to understand this better.

Asset Proportion of Assets Amt Invested % Returns Contribution Future Value after 10 Years
Equity 20% 20,00,000 12% 2.40% 62,11,696
Debt 15% 15,00,000 9% 1.35% 35,51,046
Fixed Income 60% 60,00,000 8% 4.80% 1,29,53,550
Gold 5% 5,00,000 7% 0.35% 9,83,576
Total 100% 1,00,00,000 2,36,99,868

 

            When you play a par 5 hole, you try to cover the longer distance with a driver shot and as you come closer to the green, you use shorter irons for the approach shot or a chipper to chip onto the green and finally use the putter on the green. The driver is the least forgiving club and a mistimed or bad shot can land you in the rough or hazard. However, you have chances to recover with your second or third shot. The shorter irons are more accurate and help you to close in with the pin. Finally, to sink the putt in the hole, you require precision and accuracy in speed and line of the putt for which you use the putter.

Lesson: Equity investments are akin to playing the driver shot and used for longer time horizon. A bad investment can put you in a rough or tight spot from where you can recover in due course of time. Since the market volatility will not last, the probability of negative returns also reduces with time. As you approach your financial goals, you must switch your equity investment to debt or fixed income instruments for stability and capital protection guarantee.

A dilemma for a golfer while playing an approach shot (within 200 yards of the green) towards a green surrounded with sand bunkers or water bodies is whether to attack the pin or take a lay-by. In case he plays aggressively to attack the pin and miscues the shot, his ball will land in the bunker or water obstacle from which he will find it difficult to recover or incur a penalty. If he plays safe and takes a lay-by, then he uses an additional stroke but can pull through with a good chip and putt subsequently. Golf is a game of probability and the player plays based on his potential to play the shot consistently with reasonable accuracy.

Lesson: According to mutual fund advisor in Jaipur, When you approach your financial goals, you must secure the capital from the market risks and volatility by switching it from equity to safer financial instruments. An aggressive investor may continue his equity investment with the inherent risk of capital erosion due to falling markets at the time of meeting his financial goal. A modest or conservative investor who opts for switching may earn lesser returns but will ensure that the capital is available to him in full measure at the time of his choosing. A reasonable period to switch from equity to debt funds is 12 to 18 months prior to the date of the financial goal. However, to avail maximum tax benefits through indexation you must hold the capital in debt funds for a minimum of 36 months.

MARKETS BULLISH BUT PORTFOLIOS REMAIN BEARISH

Ø  Investor Concern: Investors are concerned these days that although the markets are rising and touching new highs frequently, their investments in mutual funds (MFs) are not rising proportionately. In the last six to seven months, the SENSEX 30 navigated between a high of 36,283 on 29 Jan 18 to an all-time high of 37,606 on 31 Jul 18. The ebb came when it touched 32,596 to hit its low point on 23 Mar 18. Similarly, the NIFTY 50 traversed between its record high of 11,171 on 29 Jan 18 to an all-time high of 11,360 on 03 Aug 18 with the low point on 23 Mar of 9,998. The reasons are explained in the subsequent paragraphs.

  •  Average Returns: As on 20 Jul 18, equity large cap had generated a negative average return during the last six months of -1.85%. The multi cap generated -4.96%, whereas the mid-cap generated -10.65% and a small cap of -17.44%. Equity sector (technology) generated the best returns at 13.48% followed by debt funds at about 3 to 3.5%. The worst performer was the equity sector (infrastructure) that generated negative returns of -18.71%. Given below is the chart indicating the six months (Jan to Jun 18) returns of various fund categories as per Value Research.
  •  Market Performance: In the last three months, 26 out of 30 large cap MF schemes underperformed their benchmark. In fact, only 3 to 7 big companies are driving the market and their market caps are zooming to new highs. About 60% of the NIFTY 50 constituent stocks are in the red. Only 19 stocks in the Nifty outperformed the index with positive returns. 31 stocks, comprising more than 50 percent of the Nifty, underperformed the index. The poor conditions of the banking sector due to their large NPAs and unbelievable frauds have dipped their stocks to the bottom 10 of the list. The mid and small cap stocks dropped between 20 to 50 percent with some companies going down by almost 80 to 90 percent. Corrections in the mid and small cap space are primarily attributable to the mismatch between earnings and valuations. The stocks in the mid and small cap section had premium valuations that their earnings could not support. So their dream run of last two years started crashing after the Budget 2018. In the Nifty, only 27 percent of mid-cap and 19 percent of small-cap stocks delivered positive returns.
  • Advance Decline Ratio: The advance-decline ratio is a popular market-breadth indicator used in technical analysis. It compares the number of stocks that closed higher against the number of stocks that closed lower. If we compare the total stocks that advanced or declined at the two bourses over the last six months, we realize that the ratio has crossed 1 only in April. This indicates that in the other five months, more stocks have declined at these bourses than advanced. 
  •  Tightening of Regulatory Process: The other major contributory reason to the poor performance is the recently implemented SEBI guideline to re-categorize and rationalize the MFs into five broad categories, viz. equity schemes, debt schemes, hybrid schemes, solution-oriented schemes, and other schemes. Along with this, SEBI also redefined the market capitalization norms for the large, mid and small cap companies resulting in the eligibility of the first 100 companies only for large cap. Although this will help the investors in the long term, it has severely constrained the fund managers in the near and short term by reducing their flexibility to decide the market cap norms and switch funds to generate better alpha. Besides, SEBI has mandated all equity schemes to benchmark their performance against a total returns index (TRI), which are calculated after adding the dividends of the underlying companies. Effectively, these results in raising the hurdle for fund managers as the return of TRI indices are typically 1.5-2.5 percent higher than regular indices. Moreover, SEBI has also cracked down on MF Houses who were breaking the norms by investing outside the scheme’s mandate to generate higher returns.
  • Other Reasons: The other reason is the global headwinds generated by the likelihood of trade wars and Fed tightening. The market outflows by FIIs due to falling rupee have adversely impacted the sentiments, which the domestic investors mitigated to a large extent through their sizable inflows. At the national level, FY 2018-19 is governed by eight assembly polls followed by general elections in 2019.

Ø  Investor Advisory:

  •  The investors are advised to maintain their calm and should not prematurely churn their portfolios or exit from underperforming schemes. The market cycle auto corrected such dichotomous market situations on its own.
  • Stay invested in equity MFs while maintaining a long term investment horizon and continuing the existing SIP. The market cycle will auto correct after the political and global headwinds.
  • Watch the performance of hybrid funds over the next two quarters since they may stabilize after the turmoil created by the new SEBI regulatory order forcing mergers and fundamental change of attributes. Park your funds in short duration debt funds or FMPs to negate the market volatility and generate better returns than fixed return instruments.

PERSONAL FINANCIAL MANAGEMENT FOR THE ELDERLY RETIREES

Adopt a balanced approach to avoid impoverishment during sunset years

According to Population Census 2011, there are nearly 104 million elderly persons (aged 60 years or above) in India and their share and size is increasing. It was 5.6 percent of the population in 1961 and increased to 8.6 percent in 2011. By 2050, the population of Indians above 65 years will increase almost three times (predicted by US-based Population Reference Bureau). The growth in the elderly population is due to the longevity of life achieved because of economic well-being, better medicines and medical facilities, and reduction in fertility rates. In the urban areas, only 56 percent of male and 17 percent of the female population is financially independent while the others are partially or fully dependent. Most elderly people become penurious by falling into the financial trap due to their overcautious approach to investment. They do not realize that given the longevity, their retired life may extend for 30 or 40 years, which is as long a period as their working life or even more. When a retiree sees a large corpus available to him at the time of his retirement, he may tend to splurge by undertaking leisure vacations, gifting to his near and dear ones or even investing in some fraud schemes to get unrealistically higher returns. Alternately, he becomes a conservatively timid investor who deposits everything in safe and fixed income instruments that give lower returns. Our endeavor in this article is to look at the criticalities of financial planning and systematically explain the adoption of a balanced approach to leading a financially stable retired life.

There are two types of retirees, viz. Pensioner and non-pensioner. While the former has regular financial backing through his pension, the latter has no such guarantee. This implies that the non-pensioner will have to start with a larger corpus to sustain his monthly expenses, while a pensioner may start his retired life with relatively smaller corpus and sustain through regular pension income. Let us assume that the current monthly expense for both is rupees one Lakh, which will rise @6% per annum due to inflation. If they both live up to the age of 90 years, then their monthly expense during their 90th year will be rupees 6.02 Lakh per month. To sustain his regulated monthly expenses through 30 years of retirement, the non-pensioner requires to start with a corpus of rupees 274.74 Lakh at the real rate of return @1.89% (annual percentage return realized on the investment of 274.74 Lakh @8% and adjusted for changes in prices due to inflation @6%). Hypothetically, if the pensioner starts his retirement with a monthly pension of rupees 0.75 Lakh, he has to cater for a monthly shortfall of 0.25 Lakh and for that, he requires a corpus of rupees 68.68 Lakh.

Given this longevity of life, a question that haunts every elderly person is as to how long will he live and how much money will he require to take care of his old age? We can broadly divide 30 to 40 years of post-retirement life into 3 or 4 decades. The first decade of the sixties that holds 5.3 percent of Indian population is one of reconciliation and acceptance of the retired life and then adjusting into it. The next decade of the seventies, which is of prime concern for 2.4 percent of the Indian population, is of consolidation of assets and health. Thereafter, the decade eighties is of fragile health and growing dependence on children/domestic help for 0.9 percent of the Indian population, whose old-age dependency proportion has climbed from 10.9 percent in 1961 to 14.2 percent in 2011. Finally, only a minuscule percentage attain the extraordinaire decade of the nineties.

When a retiree invests, he is cautious, risk-averse, and puts everything in safe income instruments; so, he will not beat the inflation. Although this is sensible and apt for capital protection, it does not help to overcome the inflationary pressures. The primary inflationary pressure is from rising medical and hospitalization costs, which is about 15 percent as compared to the average consumer price index inflation rates of 6.27 percent (average monthly of a calendar year taken over past 20 years). The real rate of return of fixed income instruments is much lower than their indicative interest rate due to the taxability of the interest earned and the inflation cost. We have exemplified this point for better understanding of the readers. Rupees one Lakh invested @ 8% gives a retiree rupees 8,000 as interest in one year. If he pays 20.8 percent tax (inclusive of 4 percent cess) on it, then interest left in hand is rupees 6,336 only, which is effectively 6.34 percent. Further, 5 percent inflation eats into this 6.34 percent interest to give a meager 1.28 percent real rate of return. Since 1972, even gold has only given average 7.4 percent returns. Therefore, he must invest some percentage of his cash asset in the equity market, directly in stocks, if he has market experience and confidence, or through mutual funds, since they have given an average return of 14.3 percent in past 10 years.

The question that arises in the mind is about the asset allocation percentage. As a guideline, he must keep 50 to 60 percent in fixed income instruments to ensure capital protection, about 20 to 30 percent in equity, 10 to 15 percent in debt mutual funds and 5 to 10 percent in gold. The elderly will do well to understand the decision dilemma created due to the risky inverse relationship between the size of corpus and percentage of equity investment. If the retiree has a large corpus, then he can afford to invest a smaller percentage (up to 20 percent) in equity since his investment in other assets will take care of his financial needs. However, if his corpus is small, then he should invest a larger percentage (maximum up to 40 percent) into equity to generate better returns to meet his financial needs. Initially, the retiree may invest the retirement corpus as per this guideline through a systematic transfer plan (STP) in equity and a lump sum in other assets.

Asset Diversification Percentage Amt Invested@ Expected Returns Real Rate of Return* Inflation-Adjusted Value after 10 Yrs Inflation Adjusted Value in 30 Yrs
Equity 20% 20,00,000 15% 8.49% 45,18,037      2,30,56,281
Debt 15% 15,00,000 9% 2.83% 19,82,885        34,65,056
Fixed Income# 60% 60,00,000 8% 1.89% 72,33,195      1,05,12,063
Gold 5% 5,00,000 7% 0.94% 5,49,224          6,62,685
TOTAL 1,00,00,000 1,42,83,340      3,76,96,085
@ Assuming the retiree has a corpus of rupees 1 Crore to invest

* Assuming CPI Inflation Rate as 6%

# Includes contingency fund (equal to six months expenses) to cater for emergencies invested in Sweep FD for better liquidity.

Thereafter, he should invest to save about 15 to 20 percent of his gross monthly income in equity mutual funds through systematic investment plan (SIP) or directly in stocks. This investment will give a fillip to his savings in his eighties or nineties as their holding period would have exceeded 15 to 20 years. To illustrate and emphasize my point: A retiree investing rupees 10,000 per month in an equity mutual fund over 20 years, generating 12 percent return, will accumulate rupees 99.91 Lakh with a growth of 76 percent in his investment of rupees 24 Lakh.

He must diversify to hedge, which is a technique designed to reduce or eliminate financial risk; for example, gold and equity will offset each other if markets change. As the time goes by, the investment returns from equity start performing better than the benchmark indices since volatility decreases and so does the probability of loss, which is only 3.7 percent after 10 years and becomes zero after 15 years. If required, the retiree must make withdrawals from his fixed income instruments. The usual dilemma is how much to withdraw in a year from the fixed income corpus. Suppose a retiree invests rupees 60 Lakh in fixed income instruments @8% return in an economic environment of 6 percent annual inflation and annually withdraws 5 percent from the corpus. Then, the value of his investment after 10 years, as per the real rate of return, will reduce to rupees 43.32 Lakh. If he desires to protect his capital, then he can annually withdraw a maximum 2 percent from his corpus, to match the real rate of return @1.89%. The retiree should hold his equity investment preferably for minimum 5 years so that it can generate returns and then withdraw from it to meet financial goals or augment his sustenance income.

The retiree must also correctly comprehend the tax structure of all these assets to derive maximum advantage. Government levies tax on interest earned in most fixed income instruments, and short and long-term capital gains (STCG and LTCG) tax on equity and debt schemes at varying rates. The point to understand is that government levies tax on entire interest earned during the financial year through fixed income instruments, immaterial of the fact whether the retiree withdraws it or not for his use. However, it levies capital gains tax only on the actual gains made by the retiree during redemption or switching done in the financial year. Government adds short-term debt fund (less than 3 years) gains to the retiree’s income and taxes it at his applicable tax slab rate, whereas, it taxes long-term gains at 20 percent after the indexation benefits. This aspect and the applicable tax rates make an investment in debt mutual funds more attractive than fixed income instruments. If the retiree is in the higher tax slab with income more than rupees five Lakh, then financial wisdom dictates that his debt fund investment should be more than his fixed income investment.

Particulars Debt Funds Fixed Deposits
Investment 10,00,000 10,00,000
Return Rate 8% 8%
Lock-in period 3 3
Amount after 3 Years 12,59,712 12,59,712
Effective Return Rate 8.66% 8.66%
Inflation 6% 6%
Indexed Cost of Purchase 11,91,016
Gains (Taxed Amount) 68,696 2,59,712
Tax Paid* 13,739 80,251
Net Gain 2,45,973 1,79,461
Returns after tax 8.20% 5.98%
*LTCG Tax after indexation benefit @20% on for debt fund and Income Tax @30.9% for FD including Health and Education cess @4%

A lot is also made of investment in property for financial security and independence. In old age, the property becomes a liability due to its regular maintenance and encroachment issues. Therefore, financial prudence lies in staying cash rich and asset meager. Feel blessed to have one residential property that the retiree occupies and invests his cash assets to provide regular cash flows. The retiree must guard against holding a lot of liquid cash that he can withdraw easily or his children may coerce him to withdraw. To obviate this, he should consider making a lump sum deposit in the following instruments as they restrict liquidity and give decent returns. One, Pradhan Mantri Vyaya Vanden Yojana (PMVVY) that provides an assured monthly pension of rupees 10,000/- on maximum permissible investment of rupees 15 Lakh @8% per annum for ten years, with an option to also opt for a pension on a quarterly, half-yearly or annual basis. Two, Senior Citizen Savings Scheme (SCSS) that provides risk-free quarterly returns @8.3% (revised on a quarterly basis), on maximum permissible investment of rupees 15 Lakh for five years, which is extendable by another 3 years. Three, Government of India Savings (Taxable) Bonds, which give 7.75 percent assured returns, have 7 years tenure and no maximum investment limit. Four, Public Provident Fund (PPF) that gives 7.8 percent returns (revised on a quarterly basis) on maximum permissible investment of rupees 1.5 Lakh per year for fifteen years, which is then extendable by another 5 years. All these enjoy tax benefit under sec 80C of the IT Act, but their returns are taxable as per the retiree’s applicable tax slab except PPF, which enjoys tax exemption.