A Case study
A typical example can be taken of my friend, Rahul who was quite successful in his life. He is employed in a good Multi-national Company at a senior position earning a seven figure salary, had a beautiful wife and two children to complete his family picture and also had family assets handed down from generations.
However, when it came to his financial portfolio, the picture was not all rosy. Being financially well-off, he had many investments to his name but none of them were performing as well as he wanted. His overall portfolio returns were way below his expectations.
Faulty Investment Strategy
He consulted his friends, read market reports, changed investment strategies and zealously tried his hands at various avenues of investment hoping to get the magical formula which would quench his thirst for a decent return, yet his endeavors always met with failure. He never got around to finding the magical formula which would build up his ideal financial portfolio. Where do you think Rahul went wrong? Is there a magical formula when it comes to investments that he couldn’t find?
We toil day and night to earn enough for a stable financial future. When it comes to investing those hard-earned pennies, we always want the best possible instruments which would yield the highest returns. However, we always fall short. Have you wondered why? Why does your investment tree does not yield the fruit it should?
What is the Problem
One of the reasons why our investments fail is because we fall prey to the lure of a ‘wrong product’. Yes, investing in a wrong product is what spells the doom of our financial portfolio. But before we move of to the effects of such investments, let us first look at the bigger picture. How do you think we Indians invest in a product? There are multiple reasons like:
Recommendations of friends and relatives – Believe it or not, this crowd behavior is very common. Following the herd is a common practice and when it comes to investments, the picture is no different. My friend Rahul too consulted his peers and colleagues, and me too, when he invested and more often than not, he did invest in the products which his friends bought.
Tax exemptions – Yes, another very pertinent driving force behind most of our investments is the inherent tax relief associated with such investments. This is why come March, investors start allocating their funds fervently to various tax saving instruments to save as much tax as possible
Pre-conceived notions – Myths and pre-conceived notions haunt most of the investors who judge investments based on their perceptions which are not always correct. Busting these myths and de-mystifying such notions is very important when it comes to investments as being afflicted with perceptions would very often lead our investments the wrong way.
Lack of planning – We don’t plan on the products which would suit our needs, the risk we are able to take, the suitability of the product and thus invest blindly. This lack of planning spells our doom and results in low yields.
I am sure; you all will agree to any or all of the above mentioned points and may be a victim of wrong investment decision. If you are, you are headed down a dangerous road because investing in a wrong product spells disaster.
Top 4 Investment Faux-Pas
This is not only my opinion because I can give you four big reasons why –
Reason #1 – Risk Return Analysis
Returns is usually the most important factor associated with choosing an investment product. However, while choosing any investment product, the risk associated with that particular product is often ignored. For example, my friend Rahul is an ardent investor only in Bank Fixed Deposits without really analyzing the risk associated with the same. He is only concerned with the “Guaranteed Return” concept and hence invests in Bank Fixed Deposits only.
However, the interest earned in Fixed Deposits is 100% taxable from the first penny and the investor will have to pay taxes according to his tax slab even if TDS is deducted from the bank. This fact is often ignored.
The similar returns or marginally better returns with similar or little more risk associated along with better tax advantage can be availed by investing in Debt Mutual Funds and holding it for a period of 3 years will give him the flexibility of getting the indexation benefit and thus get a much better post tax returns.
Thus, in addition to marginally higher returns, these funds also provide the benefit of indexation which saves tax, easy liquidity and quick withdrawals. Had Rahul invested in these funds rather than Fixed Deposits, he would have enjoyed much better returns.
To understand the risk return analysis, lets us see at the image below –
As you can see that the Bank Fixed deposits and Postal savings have the lowest risk and lower return compared to Mutual Funds where one can get higher return even with lower risk. However, investing in equities has the highest risk but one can get higher returns as well.
Reason # 2 – Incorrect utilization of finances
Most of us have very limited investible surplus after the ever rising expenses of the household are met. Thus, utilizing the same effectively becomes an essential criteria in our Investment Strategy.
Our income and savings are limited and so, our investments should always be a wise decision. Investing randomly in any product or following advice of friends and without analyzing them would result in poor utilization of our financial resources which could have been put to better uses.
Economists also define a concept of Opportunity Cost which is defined as the cost of the alternative lost when another alternative is chosen in its place. So, when you invest your limited savings in one product, you are losing out investing in another, perhaps a better product with superior returns.
Not investing is a bigger crime as the value of money keeps decreasing by the day as inflation eats it up. And it often happens that some money is left unutilized or kept in savings accounts just to get the “right time” to invest.
Lets’ face it, the best time to invest is NOW and no money should be left unutilized. Timing the market is not a correct strategy for amateurs. Thus, being invested at all points of time gives the best overall advantage.
Reason # 3 – Wrong Asset Allocation
So, you planned to organize a dream wedding for your daughter yet your finances did not permit you to do so and you ended up throwing a simple party instead. Or, you dreamed up a Europe Trip after retirement but improper financial planning did not leave enough savings for meeting post-retirement expenses and you had to let go of your dream. A common experience, isn’t it? The trick in creating a sound financial portfolio is to match your financial goals with your investments. Determine your short-term and long-term goals and choose products matching your time horizon. For instance, though equity mutual funds yield attractive returns, they are more suitable for a long-term perspective than short term ones while liquid funds and debt funds are more suited for short-term requirements.
Analyzing the investment goals according to the dreams and family goals is what makes the Asset Allocation so important! Once the asset allocation is perfect, the investments are in line with the debt-equity ratio as the portfolio demands, there are no concerns with mismatch of goals verses investments!
To know your Asset Allocation, you may try this Asset Allocation Calculator.
If you have not yet planned your investments according to your various goals, you may try this Composite Financial Goal Planner
Reason # 4 – Last Minute Investment or Stress Investment
When something doesn’t go according to our expectations we often get stressed out and when it comes to finance, the stress is usually very high. The Stock Market crash in 2008 resulted in many people losing faith in equity investing because they couldn’t bear the huge losses of their hard-earned money. A wrong product has the potential of becoming fatal when the associated stress levels are heightened.
Yes, the impact of investing in a wrong product is bad. There are a lot of associated effects too apart from these big four.
Also, if one needs to plan for his tax saving investments for the year, April is a better time than March so that there is a full year horizon where the investment can be planned and executed. Also, no last minute hurry calls are taken as far as investments are concerned.
How to invest in a right product
The most obvious question which follows our discussion is how one should go about investing in a correct product. Well, the steps are simple:
Analyze your financial goals – The first step towards building a sound portfolio is the analysis of your financial goals. Just as you shop the right size in apparels, the product should also fit your goal requirements. Don’t invest in long-term oriented products when you require funds in the short-term. Analyze your requirements in terms of goals and fit each investment to your requirement framework
Shop around – Don’t depend on the recommendations of your friends or relatives or follow the herd. Compare products and their comparative benefits and invest in one which provides the best returns and is also most suitable for you. A financial advisor may be the best person to help you in this.
Play mix and match – They say that you should not put all your eggs in one basket. Yes, diversification is the key. Diversify your portfolio and mix-up your investments by investing in equity mutual funds, debt and gold in accordance to your risk profile and financial goals.
Has a disciplined approach – The last word is following a disciplined investment approach. Being disciplined is what would lead your investments to bear fruits of success. Build your portfolio brick by brick – systematically, over a long period of time.
As we discussed above, the right products chosen in accordance with your investment time horizon and risk taking ability has the potential to secure your financial future in the long as well as short term. Yes, it takes some efforts and time on your part but it is worth taking the time as its your hard-earned money we are talking about, isn’t it? When in confusion, do take help of a financial advisor.