Personal Investment management
Personal investment is the latest growing phenomenon in India. A large no of young population has been coming into workforce and enjoying disposable income. Existing workforce in private sector has also enjoyed rising salaries because of above average economic growth. This has led to banks, mutual funds, and other financial distributors vie with each other in giving active advice for personal management. However, a lot of the time the basic advice given in magazines, advertisements, etc is rather repetitive and given without backing reasoning. E.g. a common notion put forward is to take more risk when one is young, and shift towards less risk when one is older. Which means invest larger proportion in equities at younger age and move towards lower risk debt instruments when getting older. However this simple formula based investment has several flaws: 1. The amount of financial risk is not simply based on age, but on disposable income, and how much is left of that for investment after taking care of normal expenses, housing loan payments etc. If one has Rs 40,000 left after expenses for savings, it is not same as having left with Rs 15,000 for savings. The risk one can take with former is not same as reasonable risk with latter. 2. The risk of an investment is not simply based on the class of asset, but on the person’s knowledge and experience of investment and the prevailing market conditions for the asset. Investing in real estate during a bubble is risky, but not so if housing demand is driven by genuine buyers who are buying for their own residence. A few savvy investors in a favourable real estate scenario do not make for a housing bubble. Also, an experienced person who is a veteran of equity investing is taking lesser risk by investing in equities, compared to a 20 something youngster who has little family responsibilities, but has no experience of investing in equities either. To recommend to the former to get out of equities and the latter to get into equities is an advice based solely on the factor of family responsibilities, which can be tackled better in the model proposed below. Usual model proposed by financial service providers: Risk of investment = Lower risk for young working people, higher risk for middle aged and older people In more comprehensive model: Risk of investment = Investor’s skills risk + Asset class risk + Investor’s financial risk Investor’s skills risk 1. Investor’s skills risk directly depends on his/her knowledge and experience with investments in an asset class. The more knowledge and experience an investor has with an asset class, say equities, real estate or other, the lesser the risk from investor skill component. If one is not very skilled or familiar with an asset class, it is better to invest through professional fund managers in same asset class. Asset class risk 1. Some asset classes are more risky than others. It is safe to assume that government backed debt is least risky, followed by corporate debt, liquid mutual funds; and other asset classes like equity mutual funds, equities, real estate are more risky. 2. Broadly, it is prudent to divide risk asset classes into two categories: Principal secure investments: like government securities, and high rated corporate debt, debt mutual funds, pension funds. Some of these can still have some volatility based on interest rate changes, but overall these are fundamentally different from second asset class in that the principal investment is secure at maturity (for all practical purposes). Note that investment in a high-risk corporate debt should fall in the next category since safety of principal may be at significant risk. Principal volatile investments: All others like equities, equity mutual funds, real estate, gold etc. Note that gold is considered a safe haven, but as an investment belonging to commodity class, it can be volatile. Also, Investor’s financial risk This depends on investor’s own income, expenses, investments, and estimates of future needs and expenses. This is detailed further below. Total income = Taxes + Expenses + Debt payments + Insurance payments + Liquid Savings + Investments Here investments are assumed to be any debt or another asset class, which is not as liquid as cash, bank savings account, or liquid mutual fund. So if total income is assumed to be 100 and taxes are assumed to be average of 25%, following is a hypothetical scenario for a person with substantial payments on housing loan: Total income (100) = Taxes (25) + Expenses (25) + Debt payments (25) + Insurance payments (5) + Liquid Savings (10) + Investments (10) Expenses = Expenses on Food + Transport + Health + Household help etc Following percentage breakup would be for another person with no housing loan payments, but relatively more expenses due to house rent payments: Total income (100) = Taxes (25) + Expenses (35) + Debt payments (5) + Insurance payments (5) + Liquid Savings (20) + Investments (10) The most basic advice to manage finances is to live within one’s means. That means that one should manage Expenses and Debt payments carefully. Note that Expenses are month-by-month commitments and can be cut down in times of financial distress. However Debt payments on housing, automobile, or personal loan are obligations to others and once taken up, cannot be cut down easily. Next is planning for insurance. Insurance for life, house, house contents, medical emergencies, accident, automobile are necessities and one must have basic insurance cover on these. Saving on these may lead to higher savings, but exposes one to possibility of sudden financial distress in case of medical expenses or any other risk. The other advantage of having adequate insurance is that one does not need to keep high level of money in Liquid savings to meet emergency cash needs. A case in point would be cashless medical insurance available from several insurers. So what remains for savings is Liquid Savings and Investments. Note that we have not used the term Liquid Investments instead of Liquid Savings, since Liquid savings are kind of money one can dip into readily for sudden expense. One can maintain a reasonable level of Liquid Savings, and shift the rest into Investments. Now we discuss how to prepare for investments, by first looking at basic notions of financial risk. Overall Financial risk = Income risk + Expenses Risk This can be broadly expanded into: Overall Financial risk = Income risk + Debt risk + Calamity event risk Risk in one’s personal finances can happen by an unfavourable event on income side or expense side, specifically loss of income or sudden high expenses. Living beyond one’s means, which is possible only through taking increasing levels of debt (Debt risk), will directly expose oneself to high levels of financial risk over a period of time. Financial risk can happen due to income fluctuation or due to unexpected expenses. Whether one makes investments or not, one always keeps financial risk is in mind, which is why it is said that one should save for the rainy day. These rainy day savings are Liquid savings which can take care of events like loss of income due to job loss, business loss etc. If one has high level of debt payments and lesser income for a while, again Liquid savings can be dipped into to make up for shortfall. Calamity events like accidents, property loss due to theft or other calamity, and medical expenses can be mitigated to good extent by insuring oneself and property adequately. Without adequate insurance, this can cause financial hardships and may force one to borrow in times of need. If one has huge amounts of savings and investments (read high net worth), one could keep living at the same lifestyle without exhausting the funds for a lifetime. For the rest, managing financial risks is important. Having an understanding of financial risk, we can tackle specifically the risk of making investments. The main cause of investment risk happens because most principal volatile investments are not very liquid, unless one is willing to liquidate at whatever price available in market. So once money goes into Investments account, that much money is not available to manage financial risk. The main idea of managing investments risk is to understand that Investment risk must not spread over to normal Financial risk associated with income and expenses. Now if we take another look at equation of investment risk: Risk of investment = Investor’s skills risk + Asset class risk + Investor’s financial risk The last term in the investment risk refers to investor’s financial risk of income and expenses. So how can investor avoid investment risk to spread over to overall financial risk of income and expense? By making sure that the possible fluctuation of investment value does not need him/her to dip into the Liquid Savings, which are meant to take care of financial risk alone, and not investment risk. That can be done by ensuring that one has adequate funds for Liquid savings, and the investment funds are clearly separate from Liquid savings, with no need to dip into them. Advanced techniques for Investment risk management Investment risk = Investor’s skills risk + Asset class risk + Investor’s financial risk This article will not elaborate on how investor can increase their skills, since that is a topic of several books on investing. The suggested reading section in the end lists several books on investing, which are well acclaimed and known for their focus on fundamentals driven investing. It also lists some books on property related matters. We have covered Investor’s financial risk already. The second risk factor is Asset class risk, which is directly dependent on two classes of assets one can invest in: Principal secure assets, and principal volatile assets. If investor’s financial risk is slightly higher, it is recommended to have more proportion of assets in Principal secure assets. Ultimately, the overall investment risk is what needs to be seen, and investor’s skills in a particular asset must be adequate if he/she puts substantial percentage of funds into that asset class. In conclusion, it is more important for people to be able to mange their own investments and plan for retirement, than ever before. In most of the western countries, the increasing proportion of aging population has led to lesser and lesser financial security available to the elderly population, inspite of social security benefits. The same trend would be happening in other countries, for the reason of globalization and increasing competition, which is leading corporations worldwide to focus more on sustaining shareholder value and profitability, than taking care of employees and their retirement. It is necessary for individuals to gain necessary skills for investment and planning themselves for their retirement. Suggested Reading on Investment 1. The Warren Buffet Way – Investment Strategies of the World’s Greatest Investor. Robert G. Hagstrom, Jr. 2. The Intelligent investor – the definitive guide on value investing. Benjamin Graham. Updated with New Commentary by Jason Zweig. Collins Business Essentials. 3. One up on wall street – Peter Lynch, With John Rothchild 4. Financial Shenanigans – How to Detect Accounting Gimmicks & Fraud in Financial Reports. Howard M Schilit. McGraw-Hill; 2 edition 5. Property matters made easy – Indiaproperties 6. How to buy, sell, rent property – R. N. Lakhotia & Subhash Lakhotia