Viewpoint | Three blind spots to avoid in your money matters
Not saving enough, taking too much risk and buying high-cost investment products are common mistakes that can wreck your personal finance
June 28, 2019 / 09:10 AM IST
Personal finance blind spots can wreck your future. Here are the three most common personal finance blind spots and there is a high probability that you have at least one of them – not saving enough; taking too much risk; and buying high-cost investment products. We will discuss each of these factors in greater detail.Not saving enough
- Not bothering to calculate how much you require: The average person has to save around 50 per cent of his/her post-tax salary. But the proportion differs from person to person. An investment banker who has an unpredictable career should save more than the average person. So, calculate the amount based on your specific situation.
- Optimistic return assumptions will wrongly indicate that you can get away with saving less: We talk of ‘nominal returns’ in daily life—the interest rate on a fixed deposit, for example. And, nominal returns minus inflation is called ‘real returns’. Post-tax real returns, on your entire net worth, over your remaining lifetime is likely to be close to zero percent. It is optimistic to assume a figure which is higher than that.
- Ego: For example, ‘my family will get upset or be disappointed if I say that we have to cut down on our spending.’ The counterview is that your family will be even more upset or disappointed when you completely run out of money at the age of 75.
Taking too much risk
This is a common blind spot in 2019, quite different from the appetite for risk in 2008 and early 2009. The key reasons for this blind spot are:
- Believing clichés such as ‘invest hundred minus your age in equity’: If a 30-year-old was lucky and his/her ESOPs(employee stock options) worked out well, then he/she may have a material net worth. Such a 30-year-old should not invest 70 per cent of her net worth in equity because she may permanently lose half of her equity investment during a severe stock market crash.
- ‘I have to take a lot of risk because there is no other way to meet my goals’: If you have saved less than you needed to (let’s say for retirement), then you are naturally more desperately in need of high returns and hence you may be tempted to take more equity risk. But if you did that and in the rare event that the stock market crashes by say 50 per cent, then you would not be able to meet even your basic needs such as paying your rent during retirement. So, such a person does not have the financial cushion to take high risk and hence she/he should take less risk.
- Falling for the myth that ‘equity is safe in the long-term’: Over a five to 10-year horizon, there is a higher probability that equity will at least match inflation. But there is also a material probability that it will generate returns that are lower than inflation.
Buying high-cost investment products
The key reasons for this blind spot are:
- Buying whatever you are asked to: The worst financial products pay the highest commissions. And salesmen push the products that have the highest commissions. So, if a salesman is pushing you to buy a product, it is probably a bad product—insurance investment policies, structured products and credit risk funds. The best products are usually not pushed by anyone. You have to make the effort to find out about their features and buy the most suitable products.
- Overpaying in the hope of alpha: If you pay higher-than-average fees on equity mutual funds hoping to earn above-average returns, then you are likely to lose money over the long term. In other words, invest in equity mutual funds where the Total Expense Ratio (TER) is below the average.
- Buying for the sake of it: Deep inside, we wish to do the best with our investments. This is usually harmful. It makes people buy complex and dangerous products. Buy simple investment products and put your investments on autopilot.
Finding your blind spots
As mentioned earlier, there is a high probability that you have at least one of these three blind spots. So, start with picking one of the three that is difficult for you to rule out and think through the underlying reasons. The way you state the reason could be different. For example, instead of saying that ‘equity is safe in the long-term’, you may say ‘I can live with a 50 per cent fall in the stock market’. As you think through and research the topic, hopefully the flaw will strike you. The flaw here is to think that a fall in the stock market is always temporary and cannot be (semi) permanent in real value of money terms. So, the correct question becomes, ‘Can I live with a 50 per cent permanent fall in the stock market (in real value of money)?’ And more tangibly, ‘Can I live with say a 20 per cent reduction in my standard of living during retirement?’
Further, your reasons could differ from the ones listed above. For example, one of the reasons that you are not saving enough could be that you are often forced to lend to your extended family or friends and they usually cannot repay you. Or, you may have strong reasons to believe that you are a good investor and the zero real returns mentioned above won’t apply to you. And finally, some of your blind spots may be different from the three mentioned above. In all these cases, an analytical approach may help you find the flawed reasoning/assumption.
(The writer is Founder, SEBI registered Investment Adviser and Fee-Only / Advice-Only Financial Planner at Fiduciaries.in )