A Fine Balance

Typical investor behaviour—either doing nothing or too much—is hard to avoid unless you know what is just enough. A primer

Come March and most investment portfolios will see a flurry of activity, some desperate product selection, driven by the urgent need to save taxes. My friend Murali is keen to get the tax-saving investments out of his way, and then, at some point, take a closer look at what he will do with his money. Many of the products he will hurriedly choose will either languish at a low rate of return or face premature closure from his inability to pay premiums when everyday living hijacks tax-saving needs. Murali’s investment decisions are always about a product to choose, but he dislikes advisors who pitch products to him. He is not sure what to expect.

Then there is Anant, who believes that investing is about timing the markets. Anant thinks there has to be a method to predicting the direction of the market, and is unhappy with investment advice that does not tell him when to buy or sell, and feels worse still when such advice turns out to be wrong. His search of the Holy Grail of the stock market, the just-right time to buy or sell, is ever so often interrupted by rude reminders that the market is an unpredictable beast. But he ploughs on relentlessly, from one IPO to another, one stock pick to another, hoping that he will ultimately find that multi-bagger that will change his fortunes forever. He expects his relationship managers to pick up winners for him.

These two positions dominate not just the investment choices people make but also the expectations they have of their investment advisors and relationship managers. The focus on selecting the right product, premised on calling the direction of the market, tends to dominate investor-advisor interactions, with iffy outcomes at best. The alternative framework for making investment decisions—asking investors to make an asset allocation and stick to it irrespective of the direction of the market—seems somewhat theoretical. Advisors and relationship managers have no conviction in implementing a risk questionnaire and recommending a model portfolio to their clients, and investors feel they will miss out on opportunities trying to stick to the book.

With strategic, need-based investment decisions, which look only at investor needs and goals, you’ll miss out on opportunities to increase returns derived from timing the markets. On the other hand, the tactical, view-based approach, which tries to call the direction of the market, risks money to the possibility that the call is wrong. Like all good things, it is a balance of the two approaches that delivers the best results.

The financial planning approach, which asks investors to set goals and choose products based on needs, should form the core of investment portfolios. This approach keeps investment decisions well anchored and enables reviews of what has been done, keeping the goal as the reference point. Need-based investing requires an intimate understanding of the situation of an investor, something only an advisor is equipped to do.

Manufacturers of financial products are bound to churn out several variations of products, eager to please one investor segment or the other. It is amusing to watch investor groups and even regulators frowning upon producers for bringing out poorly differentiated product variations. But producing what they think will sell, and bringing them to the market when they believe the demand is peaking, is the economic function of the manufacturer. Frowning upon the producer for ‘confusing’ the investor is like asking the manufacturer of jeans to make a single size and pattern and not flood the store with minor variations to the basic product.

It is the advisors and investors who need to see what fits them and choose accordingly. Strategic investment decisions are about making choices based on need. Advisors are privy to the investor’s wealth, his goals, needs, risk preferences and returns expectations. The process that makes the advisor create a portfolio based on the investor’s specific needs is, therefore, a core strategic function of the advisor. The asset allocation decision is an outcome of this strategic function.

Investors saving for retirement need the corpus to grow into a large sum over the long period of time when they are setting aside a portion of their current income for future needs. Several tax-planning products have been created to enable this. Investing this money in a portfolio of debt securities, with the aim to generate a steady yearly income, is a serious strategic error. The pension savings of investors have been subjected to this strategic misallocation for years, leaving several senior citizens with too little to brave the inflationary pressures in their retirement.

Growth-oriented investments, such as equity, are needed to grow the corpus in size over a long period of time. This corpus can then be deployed to generate income when the investor has retired. The allocation to equity in the saving years, and the allocation to debt in the retirement years, is a strategic decision that helps this financial goal. This allocation requires no market view, but only a systematic investment over a long term.

Taking this core portfolio and tuning it to include a view on product and market performance is the tactical component of the advisory business. Tactical allocation is a value-add, it’s about advising investors to make changes in the basic strategic allocation, based on a view of the markets and, therefore, the performance of investments. An advisor might ask the investor to reduce his allocation to equity if he takes the view that the market will fall; he might seek a higher allocation to gold if he feels that gold will do better than equity given a certain macroeconomic situation. So, tactical allocation is about market timing and the belief that such calls will add value to the investor’s portfolio.

If the core of a portfolio is its investor-facing strategic allocation, the tactical allocation is the market-facing component of the investment decision. It is important for the investor to be clear if he seeks such tactical allocation, and it is critical for advisors to be equipped to deliver it. Tactical allocation demands that the advisor has knowledge of the market dynamics and the expertise to rebalance portfolios.

It is critical that investors have clarity on what they seek from their advisors. Investor-advisor interactions need to be redefined today, when regulators are urging investors to pay for advice. This is a paradigm shift from the time when producers compensated advisors for selling their products. Advisors, who earlier saw themselves as sellers of products and providers of clues to market direction, have to now see themselves as wealth managers. That’s a powerful position to be in, and should not be squandered away in all the noise over losing commission revenue from producers.

There is a clear and critical value an investment advisor brings to the investor, and a clearer definition must emerge of the value proposition and its pricing. A fund manager or investment manager, who chooses securities to construct a portfolio, goes bottom-up, looking at the fine details of a company before buying or selling. At the end of this exercise, he creates a product that is akin to a readymade garment. A wealth manager, on the other hand, is like a bespoke tailor, who makes garments made to order. He picks and chooses from these readymade financial products, guided at a strategic level by his understanding of which products will suit which customer, and at a tactical level by his knowledge of—and instinct for—which product will perform in what kind of market. The advisor who sees himself as a wealth manager takes a top-down view of investing, looking at broad choices and how they combine for his investor. If advisors see themselves as wealth managers who run large investor portfolios, they will realise that a model that makes them promote some producers for commissions is not in their business interest.

The investment advisor then has a choice: to either be a passive manager of wealth portfolios, someone who creates strategic portfolios based only on the needs of the investor, or be an active manager of wealth portfolios, which additionally entails making tactical calls on the market, and reviewing and rebalancing portfolios based on these calls. Because taking those tactical positions is a value-add, he can then legitimately expect higher fees for active management. For the investor too, this advisory dispensation will represent a clear and viable choice: those who don’t care to take views on the markets can still have an investment portfolio created and managed to an allocation that runs close to their needs while those who think timing the markets is key can go with an advisor who has a demonstrated ability to actively manage wealth.

The advisory business in India is in a state of transition. It has largely been transaction-based, where collecting investment application forms and completing the transaction is seen as a key component of an advisor’s role. Investors who simply focus on selecting a product and looking at their immediate needs do their portfolios a disservice; they need to demand and receive advisory services that take a fuller view of their investment decisions. Equally, people who think investing is about timing the market need to evaluate if their advisors have the ability to take such calls.

By choosing on a whim and reversing investment decisions in haste, people like Murali and Anant are risking their portfolios, besides passing up the opportunity to bring some calming method to the periodic madness. Murali is planning a vacation this summer and has begun to look for good deals. It is unlikely he will look at package prices and discounts before deciding where he wants to go. Anant is a backpacking fiend but thinks it is crazy to set off without a map. What they do so easily for their travels they don’t for their investments. So, what kind of investor are you? And what kind is your advisor?

The author is Managing Director of the web-based Centre for Investment Learning and Education. She has spent 20+ years watching the capital markets, both from the inside out and from the outside in.

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