Common mistakes most investors make during wealth accumulation stage

Common mistakes most investors make during wealth accumulation stage

 

’’Financial planning is a comprehensive process that, among other things, requires one to know one’s financial position, apart from identification of financial goals, estimation of one’s needs and creation a road map to achieve those goals. Investing is only a part of the entire journey of reaching your goals and should not be an ad-hoc attempt to generate returns in an unplanned manner.

’When it comes to investing in mutual funds, most investors remain in a dilemma whether they should choose direct plans or go for regular plans, continue with one’s distributor or choose between a fee-based adviser or a fee-only adviser. In an email interview, Erik Hon, Managing Director, iFAST Financial India, opens up on these situations and also talks about the common mistakes that most investors make.

Between a Fee-Based Adviser and a Commissions-Only distributor, how should an investor decide? –I think the first thing to be clear is that there is no such thing as free investment advice . The person servicing and advising the investor will have to be paid – whether by commissions or fees. The important question for the investor is: Do I want to be the one to decide what quality of advice and service I want and how much to pay for it? Or do I want the product manufacturer to decide that for me?

The traditional bundled products where costs are embedded and not transparent have led to mis-selling because there is an inherent conflict of interest when the distributor is incentivised by product manufacturers to sell their products. Having the adviser being solely remunerated by the investor ensures that the adviser is on the same side as the investor.

The adviser will then recommend cheaper alternative products that are in the investor s best interests because their income is not affected by the amount of commissions. By simply reducing the portfolio TER( total expense ratio), the investor already makes more money.

1. Proper asset allocation and managing risk exposure well without the temptation to increase exposure to equity funds that pay more commissions

2. Disciplined rebalancing in both good and bad market conditions because there is no impact to their income when switching from higher commission paying equity funds to lower commission debt funds"Other than reducing cost, an unbiased adviser can generate more alpha by:

a. Proper asset allocation and managing risk exposure well without the temptation to increase exposure to equity funds that pay more commissions

b. Disciplined rebalancing in both good and bad market conditions because there is no impact to their income when switching from higher commission paying equity funds to lower commission debt funds

Another benefit of engaging a fee-based adviser is that the investor has the power to choose the level of service required and they can stop paying fees when they are not satisfied with it. In the case of commissions, investors cannot stop the commissions being paid even when there is no service.

Direct Plans are increasingly becoming popular. Whom do they suit and what could be the pitfalls that an investor needs to be aware of? Direct plans started mainly for the institutional investors who do not require advice. It is becoming popular with retail investors because it is cheaper than the regular plans. While the lower cost of investment will help to increase alpha, the alpha will evaporate with poor emotional investment decisions.

Globally, retail investors even in mature markets like the UK and the US generally buy high and sell low. In many behavioural finance studies, retail investors act more emotionally than they think. The cost of poor or no advice will end up being more expensive in the long term because many retail investors do not invest in a disciplined and rational way and will need hand-holding, especially during the bear market.

This is why for the retail investor, unless they are very interested in the financial markets and can spend the time to manage his portfolio properly, they will be better off having a qualified adviser acting in a fiduciary capacity, like a licensed SEBI RIA, to manage their portfolio. Cost is an important consideration, but cost alone will not determine achieving the desired outcome of risk-adjusted returns in the long term.

As an investor, what should one look at before finalizing a financial adviser? Apart from ascertaining the distributor or adviser s qualifications, service offerings, experience and credentials, it is important for the investors to understand how they are being paid. If they charge an upfront fee, how is it charged? As a flat amount, or a percentage of investments made with them? Also, do they earn commissions on the investments made through them? This transparency is important for the investors to be able to judge whether any recommendations being made by the advisers are biased.

 

Secondly, investors should take the time to understand the adviser s approach do they recommend investments simply based on suitability (basic comparison of product risk and investor risk profile)? Or do they first prepare a financial plan with goals, taking your existing investments into consideration? How often would they review your portfolio? Will they rebalance your portfolio in a timely manner without worrying about loss of commissions? How frequently would they meet you or service your calls in case you have queries? Responses to these would usually differ significantly between fee-based advisers and commissions-only distributors.

Finally, a good indicator of the quality of an adviser is always the number of average years their clients have been with them.

What are the common mistakes that you see most investors make during the wealth accumulation stage? We recently did a series of informal interviews with our partner advisers across the country, and they had some interesting insights to share on investor behaviour and common mistakes they need to correct.

The most common one, I think, is where investors need to realise that their financial goals will always be unique to their own circumstances and life goals. Often, investors compare investments and portfolios with other families whose lifestyle or life stage is similar to their own. Discussing and sharing is fine, but it would be wrong to choose investments to copy someone else s success or to be able to boast about it.

The second mistake is when investors focus only on the returns, and not on the attending risks, or even on the returns they actually need to make to meet their goals. This is a mistake because the opportunity costs of getting an investment wrong today is huge. You need to earn a far higher return to recover the loss.

For example, if you ve made a loss of 25% on your portfolio, you need to earn 33% just to break even. And this is not accounting for the loss of the potential return you could have made in the same time!

 

Happy Investing