EXPECTATIONS MIS-MATCH

My first boss in my career, is highly intelligent and successful Professional. He has been very nice, straight forward, gullible person and above all really nice human being. One fine day, he called me up and just to get my opinion on his portfolio picks and under-performance what he felt in his portfolio. While reviewing the portfolio and performance, I realised that the issue is somewhere else and many a times investment related accidents happen because of MIS-MATCH in EXPECTATIONS.

Another example - one of my Corporate Lawyer friends called me up and asked me to start investing for her mother – a senior citizen. When I asked her about time frame and risk tolerance – she felt little shocked and little offended – why was I asking so difficult questions. Questions, she felt difficult, because she never thought about future investment experience. Probably, she thought that I shall provide few stock tips. I am not sure – what could be reason. But, for me, positive long term advisory experience requires some ground rules and here in this short note, I am trying to write in possible concise manner.?

As bird’s eye view, form an advisor perspective there are three steps in investment management –

1.?????Asset Allocation

2.?????Selection of right investment product or instrument, and

3.?????Review / Monitoring of Portfolio

Simultaneously, from an investor perspective the same investment process considers broadly six different but inter-connected factors –

1.?????Risk

2.?????Return

3.?????Time Horizon

4.?????Liquidity

5.?????Taxability, and

6.?????Regulatory Aspects (including succession)

Risk – Investors in their greed to maximise the return from their investable surplus, tend to ignore the risk. They tend to assume many things, which could be away from the reality. And hence here, we have placed RISK ahead of RETURN. There could be many risks pertaining to individual investment product or generic category of such product – it could be market price risk, credit risk, re-investment risk, inflation (purchasing power) risk, etc.?One needs to clearly understand which risk one is taking in which proportion, and where one has capacity to tolerate the same.

Return – One should expect return based on corresponding risk one is taking. Any product (be it financial or non-financial) when one buys it lower, there is a probability of higher return and when one buys higher, there is a probability of lower return. However, rarely one knows, when one buys / invests, whether such buying price is high or low. Only in hindsight, one realises that whether he bought it at higher or lower levels. Though in extreme price situation, it can be relatively clearer – whether one is buying high or low. Expectations of return should be more realistic, accordingly.?We suggest, when in doubt, average out your entry point over one whole price cycle by investing at regular period (systematic investing). Many a times, investors make mistake of extrapolating return numbers based on recent positive experience and then accident happens (expectation mis-match). Its like a driving a vehicle forward while looking in a rear-view mirror – this is also known as a rear-view mirror effect. Better to avoid it. ?

Time Horizon – Investors tend to get extreme optimistic or pessimistic about their portfolio return based on recent investment experience. Their time horizon also gets extended or narrowed based on such recent experience. Correct way would be – investors need to detach themselves from recency bias and think from the cash flow perspective, while keeping some safety margin in such calculations. Different investment products behave differently in different time horizons. If one invests in Equity for just a couple of months, there is a high probability that such investment may meet accident.

Liquidity – When one draws the cashflow, one can be more realistic about expectations of when one expects to get new money for investment or when will require cash-flow for personal spending. When one needs money in near future – say couple of months, it would be preferable to invest in high quality debt products. Whereas, money meant for longer term (few years), are better invested in Equity products in systematic manner. Certain financial instruments are supposed to be highly illiquid because of some lock-in condition put by the issuer (manufacturer) of the product or because of lack of depth in the market or some other reason. Such illiquidity should be built into one’s cashflow plan, to avoid any mis-match in expectations.

Taxability – Performance comparison on pre-tax basis may not be result into right investment decisions. One needs to compare post-tax return while making investment decisions. Taxation may change based on entity that is investing as well as on holding period before selling such instrument.

Regulatory aspects – There could be many regulatory aspects, based on different situations, which may affect the investment decisions. US based NRIs may not be able to make hassle-free investments in to Indian Mutual Funds, compared to listed direct equity stocks. There could be cap on some holdings by a category of investor. There could be many different such scenarios where such investment decisions could undergo a change. Additionally, one needs to be very vigilant about succession – how succession rules apply to a particular investment product. Example - succession rules could differ for Dematerialised Mutual Fund units as compared to Physical Mutual Fund units.?

Net to net, Investor needs to consider all abovementioned six factors while making any investment decision. And an Investment Advisor shall help in investor in hand holding while taking them through phases of Allocation, Selection and Review of Portfolio in providing positive investment experience in life-time advisory relationship.?