I had said in the last post that I do not like the commonly suggested method of goal based investing. Let me try and explain my objections in this post.
Firstly, the present method does not take into account how our earning capacity and therefore investment capacity will change over time. Many experts will tell a 25 year old that he has to invest 8000 Rs per month for the next 35 years to arrive at the required retirement corpus. This is absolutely meaningless – I may not have 8000 Rs to invest at 25 and may well have 30000 Rs to invest at 35. Some planners will take a percentage increment per year from a lower base figure but even this does not really address the issue. Our income pattern changes over a period of time and our investment must reflect the same.
Secondly, most experts will tell you that you must start investment in equity early as the returns are more stable in the long run. As a justification you will be shown the rolling returns of the Sensex over 15 or 20 years. However, as I explained in an earlier post the returns from equity is unpredictable and non-linear. The compounding logic that so many experts talk about really applies to debt products. So, if anything you must give your debt instruments the chance to compound for the longer period. Note that I am not talking about avoiding equities, if you have the investment bandwidth then you should do both.
Thirdly, having a separate portfolio for each goal and trying to do asset allocation at that level is completely illogical. This will make the entire exercise cumbersome and sub-optimal. You need to do asset allocation always at the overall level and never for parts. Trying to do it in this manner will mean you are missing out on the overall asset allocation that you need for all your goals.
Fourthly, because you are not looking at your assets at an overall level you will be missing out on growth opportunities. For example I may have a goal coming up this year and the equity performance is poor for the last 6 months. If I have different portfolios for my goals then I will redeem my investments in a rigid manner, even though it may not be the right time to redeem. Yes, some people will tell you that you should redeem about 2-3 years prior to your goal and shift to debt etc but that is even worse. The non-linear nature of equity returns mean that growth can happen in any year. If you redeemed your equity investments in 2013 for a goal that was coming up in 2015, you would have completely missed out on the 2014 rally.
Summing up the current method which most experts suggest is poor because:-
- It asks you to invest uniformly which is not the way your income pattern works.
- It applies compounding logic to equities which is conceptually wrong.
- It makes forming and tracking multiple portfolios a pain.
- It advises you to redeem equity in a time-bound manner which is illogical.
- It has very little flexibility in approach which is always a bad idea.
With all these flaws why is the current method so popular with investors? Well, if enough number of people repeat the same thing over a period of time most people will come to believe the same. Let me drive the final nail in the coffin with an analogy. You may be storing water in your house for a variety of purposes. Typically this will be for drinking, cooking, cleaning and other uses. Now you may require potable water for cooking, drinking and other water for other purposes. Would you store water for cooking in a vessel and for drinking in another? Would you have multiple tanks in your house for storing water to be used for non-drinking purposes?
Enough said – if you have been sucked into doing something illogical by well meaning people who did not understand the implications of what they were suggesting, it is time to change now.
How do you do that? For a starting point read my next post on how goal based investing should be done.