When decisions are goal-foolish

We often focus on visible factors and, in the process, sacrifice the important less-visible ones. This leads to inconsistencies in our investment decisions. In this article, we discuss several such decisions that we take in our investing life. Such inconsistencies are a function of our biases or systematic errors we make while taking investment decisions. We also discuss how to moderate such inconsistencies.

Inconsistent decisions

You should set up protective assets as a means of protecting your basic standard of living. This involves creating the contingency fund and buying adequate life and medical insurance. The next step involves setting-up lifestyle assets and, simultaneously, if desired, aspiration assets. Lifestyle assets are created to achieve necessary life goals such as buying a house, funding your child’s college education and retirement. Aspiration assets are created as a means to achieving your life desires such as buying a yacht or a beachfront house.

Now, consider contingency fund. This fund is created to meet medical emergencies and, in some cases, living expenses during periods of job loss. Therefore, the fund should carry liquid assets with zero tolerance to loss of nominal capital. After all, liquidity is more important than earning higher returns. And yet, that is not what most individuals focus on! You are more likely to concentrate on improving returns on your emergency cash because the cash is noticeable! And then, you may have significant capital locked-up in equity for years because you did not want to take losses on those investments!

Next, consider insurance. You are more likely to buy with-profit insurance plans than term insurance policy! Why? Because your focus is on term premiums that will not be returned to you if you survive the policy period! So, you settle for a low return on a with-profit plan. But you are uncomfortable with a similar return on your contingency fund!

Then, there is the lifestyle assets. Often, your focus will be on either protecting your nominal capital (very conservative) or earning higher returns (highly aggressive). If your focus is on protecting nominal capital, you are likely to have more-than-required allocation to bank deposits. Higher allocation to deposits means lower post-tax returns and higher possibility of goal failure. On the other hand, you are likely to have more-than-required allocation to active funds ignoring the higher risk, if you are chasing returns.

How should you handle such inconsistent decisions?

Checklist manifesto

Most of your investment decisions are routine. You save every month, and invest in the same products frequently, if not every month. You should, therefore, create a checklist and mechanically execute those decisions. Otherwise, you are bound to suffer from inconsistent decision-making.

First, your contingency fund should have some cash at home to meet payments during natural calamities when electronic networks are likely to be down. The rest should be in products that protect nominal capital such as savings account and fixed deposits. You should consider this as emergency cash, not as investment.

Second, buy term insurance policy and consider investing the difference in premium between the with-profit plan and the term insurance plan in mutual funds. Also, top-up your health-care policy to protect your medical requirements.

Third, create lifestyle assets that contains both equity index funds and bank deposits without being biased towards either. If you are uncertain about your asset allocation, start with thumb rule “100 minus age” and adjust the number according to your income risk; if your income is volatile and risky, reduce your equity allocation by 10-15 percentage points.

The point is this: Your biases are likely to distort the decisions you make during your investing life, jeopardising your life goals. So, set up automatic debits to execute the decisions mentioned in your checklist.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in