How to handle future uncertainties

While reading a book titled “The Flight Plan” by Brian Tracy, I stopped after one particular paragraph. The message was so obvious and yet profound. The paragraph reads as under:
“Perhaps the greatest enemy of personal success is explained by the Law of Least Resistance. Just as water flows downhill, most people continually seek the fastest and easiest way to get what they want, with very little thought or concern for the long-term consequences of their behaviour. This natural tendency of people to take the easy way explains most underachievement and failure in adult life.”
Why is this so important in the context of investments? What is the significance of the above paragraph when one is talking about personal finances? Isn’t finance a hard core numbers subject? Isn’t investing all about rationality?
The above paragraph relates to one’s future successes or failures. Investment is also done for certain goals in future. Future is all about uncertainties. One needs a plan and a scenario analysis to deal with uncertainties of future. A financial plan is just that – a plan to help one reach financial goals in future. If a financial plan is carefully drafted, one must adhere to that unless proven that it is a completely wrong plan or that the initial assumptions were wrong. However, often people tend to change their financial plan in light of adverse short term price movements, without giving a thought as to what inflation can do to their future finances. At the same time, people have also changed the allocation to the riskier assets looking at the recent short term superior performance.
Any investor would be better off understanding the two prime risks of investments – volatility and inflation. Volatility of prices is the short term risk – inflation is long term risk. An investment plan must be made keeping these two risks in mind.

Inflation does not affect one much in the short term as the prices of essential commodities do not rise too much in short period, normally (However, one must not forget Zimbabwe of recent times or Germany during World War II). Because of this, we tend to take inflation very lightly and ignore it while planning for our long term goals. Volatility on the other hand is an immediate risk as the prices of various securities fluctuate in the short run. This is the difference between the two risks – the former being almost invisible in the short run whereas the latter being magnified by the discussions around it. We tend to, then, overweight volatility and underweight inflation.
It is due to such behaviours towards inflation and volatility that we often tend to change the portfolio allocation to deviate from the original plan in light of price volatility. This is similar to taking the path of least resistance. While faced with high volatility or sharp drop in prices, one tends to take the path of least resistance, i.e. getting out of the wealth creating asset at the worst possible time.
While each plan needs constant monitoring and course correction, same holds true for a financial plan as well. Such monitoring and course correction for a portfolio can be done through asset allocation and rebalancing. While course correction is necessary, the key word is “correction” and not just any change. A course correction ensures one makes changes such that reaching the goal becomes a possibility. This cannot be any different for an investment plan.
Let us end this article with a quote from Herodotus (also borrowed from the same book “The Flight Plan” by Brian Tracy):
“Some men give up their designs when they have almost reached the goal; while others, on the contrary, obtain a victory by exerting, at the last moment, more vigorous efforts than ever before.”

Rajesh Nair

CEO RajRak Investment Advisors

Keep your investments separate from insurance

To an average individual, an ‘insurance’ policy is something you get returns from, not something that insures your life. Returns generated, flexibility of investment options and plans are talked about as if they are the essence of insurance. Unfortunately this is far from the truth – insurance still is very much about, and only about, covering your life! In the long run, relying on an insurance product to give you returns could be fairly counterproductive and even value destroying.
Say you are a person who is very risk-averse. Naturally, you need to be satisfied with lower returns in this case. The best ‘investment’ products for you, though they may not sound sophisticated enough, are still the good old bank fixed deposits, the PPF, the NSC and debt mutual funds. These can easily earn you double the returns of an insurance policy like an endowment plan or a whole-life plan. And if some agent comes and recommends a ULIP in such a case, this is probably worth complaining to the authorities – ULIPs are equity linked products and are risky. They are not at all suitable for a risk-averse person like you.
But say you are the more adventurous investor. Possibly you have age on your side and hence feel confident of being able to take on more risk, in the expectation of higher returns. This is a perfectly valid position to take, but now comes the next step of comparing products.
ULIPs or Unit Linked Insurance Plans offered by a majority of insurance companies provide the benefit of capital appreciation by investments in various schemes in debt and equity markets. Although this sounds like a good idea, the high costs associated with such complex products bleed you dry immediately after you pay the first premium. Worse, since you have taken the maximum loss the moment the first premium is paid, it does not matter if you choose to discontinue later – the company and salesman have already made their money from you. “More complex the product, higher is the associated cost” – is a good axiom to always keep in mind in such matters. A simple mutual fund or even a few blue-chip stocks would get you much higher returns and keep your portfolio simple to understand.
A brief comparison
For the more mathematically inclined among investors, a brief comparison would be needed to convince you of the statements made above. Let us compare your corpus and insurance cover in two cases:
Where you opted for a ULIP
Where you invested in a mutual fund; and took a term cover on your life
We have taken actual ULIP and mutual fund schemes for the following comparison.
Assume amount paid yearly is Rs. 1 lakh. Age = 24 years. Life cover = Rs. 10 lakh
Policy Term ULIPs Costs Total MF & Term Cover Cost Excess cost in case of ULIP
10 years 71,320 53,500 33%
15 years 98,620 80,250 23%
20 years 129,920 107,000 21%

Thus, ULIPs carry almost a third of additional cost. There are several other disadvantages, as mentioned below
Highly illiquid: Switch over between ULIPs of different insurance companies is not possible in case their performances are below par. Worse, most ULIPs do not even disclose details about their fund management and their portfolio to the investors
Death benefit: In case of ULIPs, policy holders gets either the sum assured or the value of the units s/he holds, whichever greater in case of death. In case of mutual funds + term insurance, one avails the benefits of both; fund value and the sum assured in case of death. Some ULIPs offer both these benefits, but their costs are even higher than mentioned above
Costs knocked off straightaway: The moment you enrol for ULIP and pay the first premium, the worst is behind you. The structure ensures that the costs are heavily front-loaded and hence an investor who exits thereafter does so at his own loss
Poorer fund performance: ULIP fund performance has been far from satisfactory in general and has often lagged behind the market. It is not uncommon to see investors who put money in ULIPs over the last calendar year and find their portfolios down to 30% of their investment – thanks to a 30% cost loading, and a 50% knock in fund value in the recent market crash
Undoing the damage
Say you have already enrolled for a poorly thought-out insurance product. Let us examine the best options to optimise your future cash flow, without worrying about the losses of the past:
If you have entered an endowment or a whole-life scheme, you can typically salvage most of the premiums paid, and earn a basic return after five years of enrolment. Five years is the best time to exit such a policy if you have a long earning career ahead thereafter. In this case, you can invest the proceeds in more carefully chosen equity related instruments so that your upside potential is higher.
Is you have entered a ULIP, unfortunately the worst is behind you and you cannot do much. Unless you are an active investor in the markets, you would be better off continuing the ULIP for the rest of its life. Needless to say, the agent may approach you after the lock-in period recommending you switch to a ‘better’ ULIP, but now you should know better! There is one to-do however - track the fund performance of the ULIP closely. If it underperforms the market by more than 5% points, you should exit after the lock-in period and go for a good mutual fund.

Rajesh Nair

CEO RajRak Investment Advisors