Financial planning – the dangers of assumption

Every half decent MBA course has a paper on Management Strategy. One of the key things taught there is the fallacy of making long term assumptions. The history of business is replete with such instances. The business of making horse carriages went out of the window when cars came into the picture, the greatly profitable luxury shipping liners became a thing of the past with the advent of airplanes. In the context of India, the flourishing textile industry was laid low when the British mechanized weaving. More recently, the innumerable STD booths in India had to shut shop when the mobile phones became available to all. I wish there was such a course on investment assumptions taught to all investors too.

Why do I say this? Let me cite a few examples, where this will become amply clear:-

• I get several people writing to me and asking whether they can take an XIRR of 15 % to 18 % for doing SIP on equity funds. When I ask them how they arrive at this figure, most say that they have been advised by people this will be the right figure to assume. Now the point is your XIRR can be in this range or it can be more or less. You need to be clear about the risks involved and have an understanding of how long term equity investment works.
• Many people make the assumption that if their goal is in 2030 then they will move out of equity in 2027 and put things in fixed instruments so that the goal amount is protected. Look at the several assumptions here – firstly, how do you know that the market will go down between 2027 and 2030? If it zooms in this period you will look rather silly for having cashed out in 2027. Secondly, your assumption is that you will redeem your equities in 2027 as the markets will be doing well – they may or may not.
• Retirement assumptions are the most hilarious – to take the expenses of a family at the peak of their life and assume that almost the same will be required in retirement at current prices is utterly ludicrous. I also suspect some financial bloggers and planners do this deliberately to scare people into investing more than is really needed.
• I have seen many youngsters assuming that their salaries will grow by 15 % or more year on year. This can surely happen at times but to assume it as an entitlement is a big folly. Let us take a person passing out of a good IIM today. He probably gets 15 lacs to begin with. In 20 years his salary then would become 2.45 crores. Possible, but only few of the batch will reach there and it will not work out for most of the people.

The point is some of these assumptions are so deep rooted that we continue to work with them, despite clear evidence being present to the contrary. Let me share a few personal examples to illustrate this:-

• In 2013 I had invested some money in Gilt funds and saw the IRR zoom up to 17 % plus when the rates started falling. I was rather tempted to shift more money into it but better sense prevailed. Within a month the rate cycle had reversed and the IRR came down sharply to 9 % and kept dropping thereafter.
• In 2013 again, when the tax free bonds were floated most people assumed that a rate of 8.8 % was really not good as the FD were giving equivalent or slightly higher rates. Within 2 years of it , the rates are down to sub 8 % for FD and the new set of tax free bonds are barely at 7.5 %.
• In 2014, I thought that my FMP investments year on year would give me adequate tax free income for running my expenses. The budget changed all of that when the LTCG duration was made 3 years.

What are some of the things that are bound to change in the near future? Well, I am definitely no astrologer but I can still dare to make the following predictions:-

• With lowering inflation, interest rates will trend to be lower than at any time in our recent history.It is quite possible that fixed income instrument returns will only be in the range of 6 % or so before long.
• What is more, it is unlikely to get back to the 9 – 10 % range that we are used to.
• With lowering of inflation the indexation benefits available on debt funds will lose it’s effectiveness as a strategy for ensuring that taxes are minimized. I am already seeing impact of it in my FMP taxation.
• Historical rolling returns between 1980 and 2015 will have little or no relevance to the returns in the next 15-20 years.
• People sneering at the tax free bond rates of 7.62 % at the highest point today will wish two years down the line that it may have been a good idea to invest in this. Again, I have many friends who tell me today that I had done a good thing in not listening to them in 2013.
• People not locking into debt long term in the hope that rates will rise in the next 2-3 years will most probably find out that they were completely wrong.
• Finally people having made their plans with 15-18 % IRR will scramble in order to redo their plans. Some of them may also completely get out of equity as it happened earlier in 2008 – 2009.

Take a look at your financial plan today and see what are the critical assumptions you have made. What will happen to your plan if they change? You cannot cover for all eventualities but you can at least be mentally prepared so that you can act quickly and decisively when you see your assumptions changing.