Be Realistic to Achieve Financial Goals

Ever wondered why some investors find it difficult to achieve their financial goals? And this is the case even for those investors with access to professional hand-holding, including mutual fund investors. Mutual funds have emerged as a preferred means to invest in financial markets and build wealth. Mutual fund schemes have seen their net asset values appreciate multi-fold over years. However, many investors do not gain as much from mutual fund schemes, even though the schemes earn returns. This, in some cases, may lead to a situation wherein the investor does not build an adequate wealth pool to meet the set financial goals. In most such cases, it is the investors’ behavioural approach to investing that is a key reason, and how this affects the management of risk of the unknown future.

Most investors are either optimistic or pessimistic. This stance is an outcome of three key factors – investor’s situation, market behaviour and recent trends. For example, an individual is expected to be optimistic if he has seen money grow in business and stocks. He may be more comfortable taking risks and want to invest in equities for high returns. But someone who has seen erosion of wealth because of reasons such as business failure, inappropriate investments (or reckless trading) or a sheer series of disasters on the personal front, such as death or prolonged illness of a bread-earner, may become too pessimistic. He may emerge a doomsayer and want to restrict his investments to those offering safety of capital at the cost of potential returns.

The optimist – one who expects a better tomorrow, or in the world of money and investments, expects better asset prices tomorrow – is likely to take an aggressive approach to investing. In some cases, aggression may lead to recklessness. The investor, over-relying on market trends, reads too much into recent trends – recency bias – wherein she may expect the performance in the short term to continue forever and end up investing aggressively. Over the long term, aggression may not always emerge as a winner. Same is the case with pessimists. Such an investor may get bogged down by uncalled for negativity and excessive focus on safety of capital. Some of these investors cannot tolerate marked-to-market losses in the short term, which may restrict them to fixed income investments with top-notch credit rating. Returns generated by such portfolios often trail inflation on a post-tax basis.

Be it optimism or pessimism, the investor runs the risk of going off track while walking towards her financial goals. Aggressive or pessimistic approaches to investing are likely to amplify outcomes on both sides, since we do not know the future. This risk of uncertain or unknown future makes investment operations even more complicated. Seasoned investors use the time-tested tool of asset allocation to mitigate this risk.

Both the optimist and pessimist are likely to ignore their asset allocation as their approach tilts it towards over-aggression or safety, which usually culminates in bringing in too high risk or curtailing potential returns, respectively. In that case, the investor runs the risk of under-accumulation in the wealth pool compared to what is required to meet her financial goals.

However, a more prudent approach could be – being realistic. A realistic investor decides her asset allocation on factors such as risk profile, financial goals and time on hand. For example, a young investor in early 30s preparing for her retirement can allocate a reasonably large component of her savings to equity investments. If she has moderate risk-taking capacity, then she can recalibrate her equity exposure to primarily Large-Cap and, to some extent, Mid-Cap segment only. The long time on hand can help her use interim volatility to her advantage.

Taking a realistic view of the financial needs can help investors make better informed decisions. It not only helps identify an asset allocation to build wealth creation over the long term, but it also helps in avoiding grave errors. For example, an investor keen to accumulate money to pay for her child’s school fee one year from now should stick to low-risk fixed income investments, even if she is optimistic about the economic growth.

A realistic asset allocation can help investors channelise their savings into appropriate investments. Regularly adding to these investments and continuous monitoring should ensure that the investor is placed on solid footing. Regular rebalancing is a must to address deviations from original asset allocation due to changes in asset prices. The original asset allocation also needs to undergo changes as the investor ages. Asset allocation also needs to be changed due to changing financial goals with upgrading lifestyle. For example, an investor may start with 80 per cent in equity, 15 per cent in bonds and the rest in precious metal. However, as an investor, her allocation to bonds should rise. This realistic approach should help investors achieve their financial goals in a disciplined manner.

To sum up, a realistic rule-based asset allocation approach can help mitigate risks but cannot eliminate the risk fully that arises while investing and meaningfully accelerate the process of building wealth to meet financial goals. Peace of mind is an invaluable by-product the investor enjoys on the way to wealth creation.

Disclaimer: The opinions expressed above are of the author and may not reflect the views of DSIJ.