Very little importance is given to the art of introspection in popular financial advice. Most advisory is focused on blindly chasing returns. However, a deeper examination of the economic rationale behind saving and investing reveals the importance of Aristotle's advice — the first step to successful investment is objective introspection.
The economic objective of investment is to ensure that future contingencies such as marriage, children’s education, recession and medical expenses do not lead to a shock to our consumption and we are able to maintain, if not improve, our current lifestyle.
While this objective is the same for all of us, since we are all at different points in our life cycle and face different contingencies, our investments should be tailored to those specific consumption shocks. This is further complicated by the fact that each of us differ in our ability to bear risk and also have differing investment horizons.
Before initiating any investment strategy, it is imperative to establish our objectives for investment.
Young investors will need to save for large future expenses such as buying a home, marriage, children’s education. To earn higher returns, they will need to have an aggressive stance towards risk and should invest more in stocks. They should avoid gold, real estate, bank deposits and government backed debt securities.
Gold returns are not driven by economic factors but inflation perceptions and thus it will not generate the returns they need. Real estate will saddle them with an illiquid asset and debt that will constrain their career flexibility while bank deposits are tax inefficient and give low returns.
Mid career investors, on the other hand, may have different objectives. They are usually looking to build a corpus for retirement and envision only a couple of large cash flow shocks such as higher education for their children and/or children’s marriage. Thus they need assets which will protect them from inflation but at a lower risk than stocks. They also typically don’t have immediate liquidity needs and can afford to lock in investments for a longer period of time. They should invest more in real estate and gold as both these assets beat inflation over the long run. They should incrementally invest less in stocks to lower risk.
Investors nearing retirement are solely concerned with matching inflation and protecting their capital. They should focus only on minimizing risk and investing in bank deposits and government backed securities.
The Indian stock market has generated returns of 12-15 per cent per annum over the last twenty years and investing in stocks fulfills objectives that require high rates of return over long holding periods.
Gold has generated returns of close to 9 per cent per annum over the last 20 years while house prices have grown by an average of 8 per cent a year over the last 10 years (Mumbai market only). Compared to this, inflation has been close to 7 per cent on an annualized basis. Therefore, while not appropriate for generating returns, gold and real estate help we nullify the effects of inflation. Bank deposits and government backed debt instruments can be used only for protecting capital and generating regular income.
Thus we see that investment objectives and the resulting strategies are dynamic and vary across our lifecycle.
Every investment carries risk. The key to successful investment is not to avoid risk but to understand one’s risk taking ability and invest accordingly. Three factors that determine this are human capital, correlation of our income with the economy and net worth.
Human capital refers to the market value of the skills that we possess. A graduate from a top engineering or business college has high human capital because it is easy for her to secure and hold a well paying job. A member of the clerical staff, however, has a much lower human capital. Higher the human capital, wider is the safety net. Therefore, those with high human capital should focus on generating returns and invest in equities and real estate. Those with low human capital should focus on loss avoidance and invest in bank deposits and government backed securities.
The nature of one’s profession also determines the ability to assume risk. Investment bankers whose job prospects are correlated to the economy are most likely to be fired when the economy tanks. A doctor or a professor’s income is not correlated to the economy at all. They can afford to take higher risks by investing in stocks.
A person’s net worth also influences her ability to take risk. A person with higher net worth has more risk taking ability while low to medium net worth individuals should focus on loss avoidance.
Another important determinant is time horizon. Stocks and real estate are volatile asset classes and generate returns only if held for a long period of time. They are unsuitable for short holding periods as it exposes the investor to the risk of being forced to sell them at low prices in the midst of a downturn. Additionally, real estate also carries a significant amount of liquidity risk making it especially unsuitable for short holding periods. Short horizon investors should therefore studiously avoid these asset classes.
Bank deposits are more suitable for short holding periods. Therefore, every investor should understand her time horizon and invest accordingly.