Portfolio Ideas. Balancing your present and future self

Your brain is eternally engaged in a battle. Should you eat dessert or start a dietary plan today? Should you spend more today or cut your spending and save for the future? It is difficult to make decisions when your present self is engaged in a battle with your future self. Why bother about saving for the future when you can enjoy the present? The typical advice is that you should distance yourself from a decision such that your present is not hurt and yet your future is cared for. In this article, we first show how systematic investment plans (SIPs) help balance your present and future self. We then focus on financial decisions that require active interventions to protect your future self.

Commitment contracts

SIPs are behaviourally optimal as it pacifies both your present and future self. You can set up an SIP that allows your preferred mutual fund company to automatically debit a pre-determined amount every month from your savings account and invest it in the fund of your choice. You can then spend the rest in your savings account. So, your present self is happy because you are not “visibly” cutting your current consumption and your future self is taken care of because you are saving to meet a life goal in the future.

Importantly, SIPs help moderate regret because you do not take active decisions every month. An active decision is one where you have to make a choice on whether or not to do a task. Suppose you decide to manually invest every month in an equity fund. This means you have to take an active decision each month. And that could lead to regret. What if the market declines after you invest? Or what if the market moves up sharply and you did not invest enough? A SIP distances you from such decisions after setting up the process. That said, you need active interventions in certain cases to protect your future self. Why?

Active interventions

By active interventions we mean that you have to manually take actions to protect your future self. We discuss three such decisions here. While two relate to investment decisions, one relates to your spending decision.

Consider the investment decisions. You should not have long-term SIPs on active equity funds. Why? You buy such a fund to not only achieve your life goal but also generate positive alpha, which is the excess return you generate over a benchmark index. You have to, therefore, evaluate your investments annually to validate if the active fund continues to serve your dual objectives.

Therefore, SIPs on active funds should be set up for not more than 12 months at a time. Of course, you should brace yourself for any regret that may arise from active interventions.

You should also make active interventions to take out unrealised gains on your equity investments in excess of your expected return.

Suppose you expect to earn 12 per cent pre-tax annual returns for the next 10 years to achieve a goal. You should take out the returns in excess of 12 per cent to protect the additional gains.

This active intervention has to be done annually or at any time during the year when the equity portfolio carries returns in excess of 12 per cent.

You should not set up an automatic transfer even if such a facility is available.

Why? You could, in some years, face losses or earn lower-than-expected returns.

Active interventions will help you catch such value gaps in your portfolio, forcing you to take action to bridge these gaps.

Finally, you should not set up automatic debits to pay your recurring expenses such as utility bills and credit-card payments. Active intervention enables you to observe your spending patterns.

That way, you will know how to control your expenses, if required, at a later date.

The writer is founder of Navera Consulting. Send your feedback to portfolioidea@thehindu.co.in

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