controlling your financial destiny v2 dec 06

7/31/2019 Controlling Your Financial Destiny v2 Dec 06

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Controlling your financial

destiny

December 2006


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Contents

Need for financial planning Importance of financial planning Creating and managing wealth Income and Expenses Savings and investment Investing.

What is investing ? Asset allocation Importance of asset allocation What is risk ? Investment versus speculation About Dalal / Wall street Myths and mistakes

Equity investing Using Mutual funds

Is a good financial plan = happiness ?


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Need for financial planning

Timing mismatch between income and expenses: Bulk of earnings are in ages 22-55 but expenses are in ages 22 till

death. In some years, expenses are more than earnings marriage childrens education, childrens marriage parents healthcare own healthcare post retirement, etc.

Spending years : earning years > 5:3 (more depending on longevity)

After retirement from an active career, a prolonged deficit period startsuntil death.

Helps to identify risks and manage those which can be managedand be aware of those which are beyond management Insurance- Life, health, theft

Helps to plan and make adjustments before it is too late Actual cumulative savings at retirement

= fn {Income and expenses, pre-retirement, lifestyle} Cumulative savings required at retirement

= fn {expenses, post retirement, lifestyle} An early warning system helps create a Plan-Do-Check-Act Cycle !


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Increasing importance of financial planning

Shift from Patronizing employer to Arms-length employer. All benefits upfront. A mutual What have you done for me lately approach No more defined benefits such as pensions, post retirement healthcare only defined contribution such as Provident Funds especially in Private Sector.

Tax environment has changed upfront compensation structures also Pre-liberalization, consumption choices were limited as tax structure heavily tilted

compensation towards perks such as housing, car, loans rather than cash. With lowdisposable and discretionary income, minimal financial planning was possible.

Now, compensation is tilted heavily towards cash with minimal perks. Entire onus ison the individual to manage his consumption and finances.

Longevity increasing; but careers shortening and aspiration for earlyretirement Longevity in white collar urban strata pockets likely to reach 90 years

Better

Healthcare

Need for More

Savings

More Longevity

Better Healthcare: A double edged sword !


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Increasing importance of financial planning

Earning saving paradox: Maximum savings can be done in boom yearsbut paradoxically many are spending more in boom years

Increased amplitude and frequency of economic cycles some yearsprovide a one-time kicker, never-before-like earnings (Ex: ESOPs). This wasnot the case in pre-liberalized era.

Economy are more inter-linked- factors beyond ones control play a largepart in our income.

Creation (saving) and management (investing) of Wealth is as

important if not more than earning alone. Saving well and investing has a better co-relation with wealth than justearning not my words but Warren Buffetts


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Creating and managing wealth

Set reasonable goals and work towards acheiving them

Reasonable goals set in a self-reinforcing behavioural pattern and vice versa. If you even beat inflation by 3-4% over your career, you should be in the highest

percentile of savers

"You cannot cheat an honest man- W.C. Fields Be thrifty

Mathematically the effect of thrift is the same as that of additional

income ! Expenses are more controllable than income. Start saving and investing early. Benefit of compounding kicks in early You learn at a much lower cost as you dont have much to lose More time to learn and less pressure

Focus on the long term and on your entire networth..

Divide surpluses into long term and short term surplus. Deploy in suitable financial instruments depending on risk appetite and

comfort levels. Create a yearly income expense budget (P&L) and aNetworth tracker (Balance sheet and have a yearly savings target

Analyze and review periodically and take corrective action, if required Important Pre-requisite: Getting info & storing it efficiently


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Income and Expenses (P&L)

Income Effort based Salary

Asset based Interest

Dividends

Rent

Expenses Recurring Housing

Transportation

Food

Entertainment

Education Personal care

Parents/dependents

support

One-time

Children college education

Marriage

Asset purchases Ex: House,

Cars, White goods

Income

Expense

Savings

Retirement Time

Asset based inflows kick in only when you start saving ! Post-retirement from active career, most outflows are met from asset base income. Most common mistake is to delay creation of assets Media has become a huge selling machine converting wants and desires into needs Development of independent judgement, postponement of instant gratification required !


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Assets and Liabilities (Balance sheet)

Liabilities

House loans Car loans

Other loans

Your Networth

Assets

Earning assets Bonds

Equities

Provident Funds

Bank balances

Life insurance

encashment values ESOPs- post tax value

Houses and real estate

Assets by name only

Owned and occupied

house

Cars

Art, household objects etc


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What is investing ?

Investment is process of deploying this surplus capital in variousassets in the interim period between surplus years and deficit years

so that : Effects of inflation on purchasing power are neutralized. (Post

tax returns at least equal inflation)

Purchasing power of these surpluses are increased to the extentpossible. (Post tax returns beat inflation)

Asset classes Equities: Stocks, Mutual funds

Debt: Fixed deposits, bonds, Mutual funds

Real estate: Houses, land, Mutual funds, Equities

Precious metals and currencies


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Asset allocation

Asset Allocation of investments depends on

Time period between surplus and deficit years If the period between surplus and deficit years are more than say 3 years or

more you could invest such funds in Equities.

Funds which are required in a shorter time frame should be invested ininvestments with similar maturities such as Liquid funds, Bonds and Fixeddeposits.

Risk and returns Risk appetite : Is it a constant ? Effect of awareness and learning on risk

appetite ?

Is volatility a risk ?

What is risk ?


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Extra return over inflation has a geometric relation to Cumulative savings

at the time of retirement !

Compounding is the eighth wonder of the world Albert Einstein

S

u

r

p

lu

s

Cumulative savings return = inflation

Cum. savings returns beat inflation by 1%

Cum. savings returns beat inflation by 5 %

Retirement

Cumulative savings return < inflation

Cumulative real savings including investment returns

Time

Importance of Asset allocation

N.B: Not to scale


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What is Risk ?

All asset classes contain risks. The risks are different in different assetclasses.

Bonds and currencies carry risk of losing substantial value over longperiods of times even in the best of countries. Inflation is the mostdistinguished form of robbery since the invention of paper money practicedby governments all over the world.

Bonds do not compensate owners fully for inflation- the entire interestamount is taxed rather than the surplus over the inflation. A patently unjustarrangement !

A short period of high inflation can wipe out huge purchasing power. Indianretirees of the 80s and early 90s lost substantial purchasing power between1993 and 1998!

Ownership of stable businesses protects your purchasing power better ininflationary times than owning IOUs.

Equities is like a surgeons knife. It can benefit us or harm us depending onhow it is used.

Main risks in equity are purchasing equities at the wrong valuations/times Speculating in equities rather than investing in equities.

History suggests that wars, inflationary governments are regular

occurrences in the long sweep of time. Hence bonds as a long term asset

have as serious drawbacks as equity.


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Investor vs Speculators

Stocks represent fractionalownership of businesses

Buy and sell on the basis of pricesof securities as compared to theirintrinsic value

Buy when returns outweigh risksand sell when return no longerjustifies the risks.

Benefit from free cash flows ofbusiness, dividends and narrowingof gap between the price andvalue of the security

Investors have reasonablechances of achieving long terminvestment success

Stocks represent prices of paperwhich oscillate in value and whichcan be traded

Buy and sell when they believeprices will rise and fall, not onfundamentals, but on decisions ofothers

Buy when stocks moving welland sell when they are goingdown.

Speculators are obsessed withpredicting the direction of stock

prices in the short term day,week, quarter.

Speculators are likely to losemoney over time


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About Dalal Street and Wall Street

It is absolutely essential to understand the nature of Dalal / Wall Street tomanage your finances

Dalal / Wall street performs many important functions but also has keydrawbacks Conflicts of interest Short term orientation Compensated for what they do rather than for how well they do it hence a bias

for frequent transactions. Always bullish

Dalal / Wall street exists to largely serve itself not its customers.

IPOs A case of Whose bread I eat, his song I sing New Fund offers versus Existing Funds Sectoral funds Listed closed end funds and why no adviser recommends them !

Dalal / Wall Street operates on caveat emptorThe large print giveth and the small print taketh away Anonymous

All asset management activities and wealth management services areactually Professions with certain aspect of business.. but they run asBusinesses with certain aspects of profession.


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Myths and Mistakes

Retirement Financially speaking, current life expectancy and savings/spending patterns mean that most people

cannot retire at 40.

To retire at 40, with a life expectancy of 80 and post tax investment returns equaling inflation, oneneeds to save at least 66% of ones post tax income !

Non financially speaking, early retirement without an idea of what to do next is a great recipe for adisaster.

Speculation - A bad idea at all times ! There are two times in a man's life when he should not speculate: when he can't afford it and when

he can. Mark Twain Never leverage any of your investments i.e, dont borrow against existing investments and buy

more. A timing mistake can wipe you out. Leveraging is the hare strategy and thrift and compounding is the tortoise strategy of wealthcreation.

Tax saving Tax saving per se is not good and should not be an investment goal. Minimizing taxes does not maximise the post tax return. Many insurance products produce very low pre-tax returns after fees. Buying houses only to use tax breaks belongs to the same category.

Falling in love with your investments Be disciplined, being emotional with investments can be a very costly mistake

Good companies and good investments are two different concepts A good company is one which earns a sustainable high return on its invested capital A good investment is one which makes good returns for the investor All good companies are not great investments. It depends on the price you pay.


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Myths and Mistakes

Short term-ism Most human suffer from loss aversion i.e, Rs of profit is equal to almost Rs 2.5 of losses. More often you monitor your investments, higher likelihood of loss aversion kicking off.

Reasonable expectations Have reasonable expectations grounded in reality and past experience Over a long term the entire stock market cannot deliver more returns than the return on capital of the underlying

business Unreasonable expectations cause people to be reckless or take excessive risks thereby reducing the potential

returns and reasonable expectations people to be cautious get more returns than they expect- a paradox. Late starters typically want to play catch-up and tend to fall for promises of excessive and unreasonable returns

Understand risk Every bonds is a business and every business is a bond

Understanding the past Past has inverse co-relation with the future. Periods of high excessive returns are usually followed by periods of

low or negative returns US market: 1966 to 1982 Lessons for the current Indian situation ?

Houses as investments The house your live in is an asset only as per the dictionary Economically, it is a pre-paid expense instead of paying rent monthly, you paid lifetime rent ! The more capital you lock up in the house you live in that is far beyond your requirements, the more you consume

Bonds are not great investments for the long term. Currencies even in the best of countries lose substantial value over long periods of times. It is the most

distinguished form of robbery since the invention of paper money. Bonds do not compensate owners fully for inflation- the entire interest amount is taxed rather than the surplus over

the inflation. A short period of high inflation can wipe out huge purchasing power. Indian retirees of the 80s and early 90s lost

substantial purchasing power between 1993 and 1998! Ownership of stable businesses protects your purchasing power better in inflationary times than owning IOUs.


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Perils of numeracy

Numbers can be misleading.Our best defenses against numerical illusions of certainty are

the immeasurable, but nonetheless invaluable, qualities of perspective, experience, commonsense, and judgement. John Bogle

The first step is to measure what can be easily measured. This is okay as far as it goes. The

second step is to disregard that which cannot be measured, or give it an arbitrary quantitative

value. This is artificial and misleading. The third step is to presume that what cannot be

measured really is not very important. This is blindness. The fourth step is to say that what

cannot be measured does not really exist. This is suicide. John Bogle

Overstating the value of unlisted investments

Many investors avoid listed securities because they oscillate in value !

The organization of the capital markets required for the holders ofquotedequities requires

much more nerve, patience, and fortitude than for the holders of wealth in other forms . . .

some (investors) will buy without a tremor unmarketable investments which, if they had

(continuous) quotations available, would turn their hair gray. Keynes Fixed deposits, art, holiday homes, pieces of land in the MON*, belong to this category.

* - middle of nowehere

Myths and Mistakes


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Equity investing

Equity investing is a very important tool for conserving and improving the purchasing

power of your savings

Equity investing can be done in 3 ways Directly pros no fees, lot of time investment is required, competence is also required.

Through mutual funds

Through Portfolio managers, investment advisors etc

Mutual funds are like democracy. They are the best route* despite their drawbacks

* - The best route is to find a superb advisor if you are lucky !


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About Mutual Funds

Benefits Ease of operation

Provides diversification with low effort Managed by qualified people. Tax advantages deferral of gains

Problems Conflicted business models

Fixed fee leads to impetus for size over quality of performance.

Larger funds have fewer attractive investment options and hence are likely toperform poorer but they earn the highest fees for the fund manager. Launch funds when they can sell not when they will make money.

Short term orientation and wrong benchmarks Most have relative performance targets for every 3 and 6 months No fund manager wants to stand out this leads to closet indexing and herd

behaviour / groupthink

Giant selling machine rather than a performing machine Sectoral funds High NAV of an old existing fund doesnt mean it is costlier than an NFO.

"This fishing tackle manufacturer I knew had all these flashy green and purple lures. I asked, Do fish take these?""Charlie, he said, I dont sell these lures to fish." Berkshire Hathaways Charles T. Munger, as quoted in Fortune.


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About Mutual Funds

What to do ? Train yourself to choose mutual funds most advise is highly conflicted and can be

worse than your own judgment ! You can outsource your financial literacy ! Accept caveat emptor and act accordingly Choose fund houses with Investment management in their DNA. Avoid fund houses

with hot money flows. Conserve your attention span : Do not buy into too many funds. This makes

monitoring very easy. If they are benchmarked against the same index, they are likelyto be equally good or bad !

Learn to read the fine print : Track changes in Fund managers, read and monitorfees, compare performance (not more than once a year).

Buy funds which are value oriented and have avowed strategy of buying cheapstocks

Follow these rules to improve your prospects Buy smaller sized funds and avoid large funds Avoid New fund offers and sectoral funds. Buy into existing funds. Avoid complex products and one with many layers of fees

Buy good listed close-ended mutual funds, if available. Ex : Morgan Stanley Growth Fund Invest more in down trends but if you do not have the stomach for that use SIPs Find a good fee only advisor, if you can !

If you cant understand all of this, use the cheapest Index fund and get into a SIP.


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Is a good financial plan = happiness ?

A good financial is a necessary condition but not sufficient condition

for happiness

Other requirements are

Flow in professional life : Living a life with meaningful challenges

which engage us and allow us to grow every day in a personal and

professional manner.

Flow in personal life: Cultivating and maintaining meaningfulrelationships with friends and family, which are nurturing

Flow in retirement and preparing for it

Longevity of life is increasing the number of years between retirement

from active careers and death. People have active skills and can be of

great use to society and to themselves Retirement as a flip switch power and peer relationships.

Most of todays white collar workers may not want to live life at a hectic

pace beyond mid-50s. They need to reinvent themselves- at varying

stages depending upon the time at which they switch from a traditional

corporate career at a large firm.


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Thank you

controlling your financial destiny v2 dec 06

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