India’s property market is fundamentally flawed. It is unusual in any part of the world that one would borrow at 10-12% and willingly accept a yield of 2%, on an asset where capital appreciation is marginal or non-existent.

Why is the real estate market so out of kilter? The imbalance between investment and return can be squarely attributed to the large parallel economy in the real estate market. Larger the volume of black money, higher the cost of real estate.

There are three constituencies who participate on the demand side of this market. The first is those who buy property because they need a place to live. This group is the most authentic, natural market. A larger proportion of this group will ensure a long-term, sustainable growth.

The second is those who buy property to rent. People have surplus cash, and like their investments in other asset classes, they invest part of this surplus in property. They hope to derive a rental yield, or perhaps sell the property for capital appreciation. Without placing big bets on capital appreciation, robust rental yields are an indication of a developed property market. In most parts of the world, the buy-to-let market is a significant part of the overall property market because of its healthy returns.

The third constituent comprises of people who have surplus cash that they can’t fully account for. It’s not easy to deploy such money into financial markets because it leaves a long trail. That money historically, and even today, finds its way into gold or property. The buyers wanted an avenue to route black money to avoid scrutiny. For the longest time, no questions were asked. Many builders used this money to settle payments towards the unorganised sector such as labourers, contractors, sometimes even mafia.

As a result, people who bought property with such concealed cash did not expect any return on investment. Their behaviour was akin to hiding money under a mattress. The property could even be locked for decades to avoid tenancy hassles. Even when it was rented, they were happy with a trivial rent, and that is the reason today’s rental market is content with a 2-3% yield.

The NDA government’s thrust on eliminating black money resulted in demonetisation, post which a large amount of unaccounted cash found its way into banks. We see that as the pressure on the parallel economy increases, regulations strengthen and RERA grows teeth, each property transaction will become trackable and traceable. This will result in more builders becoming organised and professional, eventually leading to the decline of black money in this sector.

Every market operates on the principle of demand and supply. In the real estate market today, there is excess supply and low demand. With the tightening around regulation and compliance, the cash component of the real estate market has shrunk, resulting in dwindling demand. Also, people who bought property to sell find that they are having to sell at a loss. To avoid the loss, they postpone the sale, thereby minimising real estate transactions.

When demand starts to shrink, there will be pricing pressure. Prices must fall and reset to reactivate the market. A new equilibrium must be established for the market to stabilise. When this new price level is reached, the cost to acquire property will be less, translating to higher rental yields.

What does all this mean for someone who owns a property and is looking to sell; for a tenant; or for someone interested in buying real estate today?

From an owner’s perspective, you may find yourself in a situation where you are unable to sell your property even at cost. You can either hold on the property and hope that prices increase in future, or you can choose to sell at a lower price today, invest the proceeds in another asset that grows faster and recover your loss.

If you’re a tenant and not approaching retirement anytime soon, it may be a good idea to continue renting. If renting property is not such a great deal for a landlord, it is a great deal for a tenant. You can live in a ₹1 crore property by paying rent at 2-3% of its value. Not owning a property gives you the greatest flexibility in terms of job changes or location changes. However, if you’re approaching retirement and don’t want to deal with the uncertainty of living in a rented property, you can buy property provided it doesn’t affect your financial independence.

As an investor, you are aware that the property market is not likely to go through the roof anytime soon. Unless you find distress sales, it may not be worth participating now because you would be better off investing in other asset classes that have a faster rate of growth.

The post Time to get real about prospects of real estate appeared first on PeakAlpha.

By Priya Sunder

Investing through a structured planning process is the best way for people to meet various goals in their lives. Without a plan, an investment is simply a transaction with no specific direction. Such investments, perhaps, make sense for people looking for capital preservation because they don’t need growth; or for people looking for growth, because they have adequate assets in risk-free investments. For everybody else, who need direction in determining and maintaining the right blend of safety and growth in their portfolios to meet life goals, financial planning is the way to go forward.

In order to create and administer a properly structured plan, one must understand the client’s goals, determine the risk required in the portfolio, the right asset allocation and then specific instruments. Hence, it is the goals that drive the level of risk, and not the other way around. Only when an advisor aligns the goals, risk requirement and risk appetite of the client, will he be able to construct optimal portfolios.

Easier said than done. The problem with most plans is that an investor’s risk tolerance varies constantly during the investment journey. It is common to hear from clients during the planning process that they are willing to take high risk for a high return but when the rubber hits the road, and the markets go through the kind of turmoil as today, their risk tolerance drops drastically. Alternately, an investor’s risk appetite and risk requirement may be low, but they are disappointed when the portfolio generates single-digit returns.

Mr X, a client, called me recently in panic and said he wanted to sell his entire equity mutual fund portfolio and invest it in fixed deposits. The market drop in the last few months had brought him to this interesting conclusion that he would be better off playing safe.

Here is the situation. Mr X has about a decade more to go before he retires. His financial portfolio requires 40% exposure to equity to meet his retirement goals. His current portfolio is perfectly balanced between equity and debt. He now wants to go 100% debt and 0% equity. If I let him have his way and move all his assets to debt, he would run out of money seven years into retirement. The withdrawal rate required to meet his expenses would not match the growth in the portfolio. In order to meet his expenses comfortably, his portfolio would need to grow at more than twice his withdrawal rate. To match this required growth rate, he will need to have a blend of both equity and debt in the portfolio, in the right ratios.

What should an advisor do in such a situation where her client’s risk appetite does not match his risk requirement? Here are the options: 1) Acknowledge the client’s nervousness in volatile markets, change the portfolio to accommodate his wishes and move the portfolio to risk-free assets. This could mean that the client may not achieve his long-term retirement goals because the overall returns may fall short of the required return. 2) Hold your ground, advise the client to avoid knee-jerk changes to his portfolio and encourage him to stay the course of the plan. 3) Incorporate the client’s inputs, re-craft the plan, revise his goals and inform him that though he may not sustain his current lifestyle after retirement, he will be able to afford a lifestyle a few notches lower.

Option 1 does not work. Investing in line with Mr X’s risk appetite, which keeps fluctuating through market cycles, will make his portfolio either too risky or too safe and may compromise his financial independence. Also, financial advisors are not order takers. They understand your desires and goals, assess your financial situation and create a road map to help you get to your goal in the most efficient way. If investors knew what is best for them, they would be better off without an advisor’s help.

I would go for Option 2 or 3. Option 2 helps the client stay true to his plan and prevents him from changing course each time the market shifts. Option 3 meets the advisor and the client’s requirements midway, though it may not deliver the most optimal or efficient return on his portfolio. However, this option may lead to moving goalposts if the client’s risk appetite does not stay consistent.

In conclusion, risk aversion is a luxury few can afford. Investors need to be mindful of the future costs of inconsistent behavior. They would be better off fastening their seat belts, staying the course and driving towards their goal. If not, they will lose control of their plan, and get taken for a ride instead.

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By Priya Sunder

A well-known folk tale tells the story of six blind men meeting an elephant for the first time. The first man touches the pachyderm’s large, wide body and said the animal must be like a wall. The second feels the long trunk and remarked the elephant must look like a snake. The third felt the thick legs and guessed the elephant must resemble a tree and so on… Each blind man imagined his version of the elephant and none of them were right. This story rings true even when we observe investors’ behavior towards their portfolios. Like the blind men’s limited perspective of the elephant, each investor’s understanding is random, incomplete and unique, but very often far from reality.

Investor A’s experience can be unlike Investor B’s because Investor A could have bought when the markets were low whereas Investor B would have waited on the sidelines during market slumps and invested when it rose. Investor A could have invested steadily via SIPs or STPs, thereby averaging out his returns better than Investor B, who chose to time the market and invest lump sums. Investor A may have stopped himself from moving in and out of schemes frequently, whereas Investor B may have chased the best performing fund and churned his portfolio often. The timing of the investment and the time spent in the investment can be different for each investor.

Then there are differences between the returns of a scheme and an investor’s returns. Often the investor’s returns are low even though the fund has had a stellar performance in the past and continues to be a high-ranking fund today. A scheme may show a 16% CAGR over 10 years in the fact sheet, but in your portfolio, the scheme shows only a 6% return. How does one explain this?

A fund’s total returns may measure its performance across a 5- or 10-year period, or perhaps since inception. However, an investor’s tenure may not match the fund’s tenure. Even if it did, investor behavior may be different from a fund’s behavior. An investor may have entered the scheme five years ago through an upfront investment, continued a SIP for two years, redeemed after four years and invested a further lump sum in the fifth year. For an investor who has a SIP running in a fund, the tenure of his first installment may have delivered long-term returns that matched that of the fund, but his most recent installment may have had zero or even negative returns, depending on the prevalent market conditions. An investor’s returns are weighted based on his cash inflows and outflows, which in turn are skewed by his behavioral biases which influences when he enters the scheme, how long he stays invested, when he chooses to exit and so on.

The internal rate of return (IRR) is a tool used to measure an investor’s return on his investment. It includes the value of all the inflows and the outflows at different periods of time. The investment’s return is a different calculation. The data that you see on a scheme’s fact sheet or prospectus is based on the scheme’s total return, which includes growth in the portfolio as well as income generated by the investments in the portfolio over a period. When the IRR is less than the total return, it could indicate that the investor may have entered when the returns were high and exited when the returns were low.

When an investor’s time horizon converges with the that of the scheme, the gap between investment and investor returns shrinks. The gap tends to be starker in the case of schemes which have higher volatility or during times when the markets are choppy. This is primarily because investors may not be able to stomach the ups and downs of the markets or the scheme’s performance. Such volatility makes them nervous and they may exit when the returns are low and re-enter when the markets look more promising. This is so true of investors who exited during the lows of 2008 and re-entered when the market was on the upswing. This is precisely the sentiment that investors should avoid in today’s turbulent markets.

Studies have shown a nearly 6-7% difference between investor and investment returns. It’s important to learn a few lessons here. One, if the scheme is of high quality, then have conviction and stay invested. Two, don’t let behavioral foibles come in the way of disciplined investing. Three, stay the course with your goals and target asset allocation. Exit when this balance is off or if you need money. Everything else is irrelephant. Sorry, irrelevant.

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By Priya Sunder

As a financial planner, one of my greatest joys is in delivering an epiphanic moment for a client—that instant when he realises the potential of money and what it can do for him. That point where I weave together all the money decisions he has made in the past and the decisions he will make and draw a map for where those decisions will take him in the future. That’s when all the dots are interlinked, and everything hangs together beautifully. The purpose of money becomes crystal clear. Sometimes these money decisions do not make much financial sense, but they make utmost psychological sense. This is where personal finance gets up, close and personal for the client. This is when I feel I’ve done justice to my job as a financial planner.

Financial planning is the skilful synthesis of art and science. It’s a profession that requires emotional intelligence more than intellectual intelligence. It’s all about knowing what makes people tick, finding out their deepest aspirations and seeing whether they have a fighting chance of fulfilling those. Creating the right financial plan requires going down a long path of self-discovery, asking lots of open-ended questions and listening carefully to a client’s fears, hopes and desires. It’s about empathy, human psychology and a very deep level of trust between the planner and client. Sometimes this trust is so strong that the client and planner share information that even the client’s family is not privy too.

Money is supposed to free you, not shackle you. I have advised countless people to retire early and pick up an alternate career or vocation if their plan permitted them to do so. Recently, we helped a client realise a long-standing dream of being a wildlife photographer. Yes, it entailed compromises and trade-offs and several lifestyle changes. And it did not make financial sense to pursue this career compared to his previous one. He would have been far wealthier in his previous job. But money can only buy so much happiness. Once we charted the course for how he could get to his goal, the client got his epiphanic moment right there. He got what he wanted from the plan and we knew how to deliver what he wanted. The scientific aspect of financial planning then took over and we created a comprehensive plan that factored in the client’s current assets, cash flows, liabilities and risk and then structured it in such a way that what was once a farfetched goal was now within touching distance.

Or take the case of a couple who wanted to create an animal welfare fund but were unsure of whether they could retire comfortably by doing so. Or the instance where a client quit a well-paying consulting job to start her own line of clothing. There are so many such stories… people wanting to retire early and join politics, start a brewery, or open a philanthropic organisation. Most of these aspirations are achievable.

On the flip side, often clients hang on to aspirations that may not be financially viable, either because of limited time or resources or both. It is the planner’s job then to also drive home the truth. It may crush them at first, but they will realign themselves to a new normal soon enough.

Financial planning is not limited to asset allocation, retirement planning, children’s education corpus building, or innumerable scenario analysis. If that were the case, there would not be a profession called financial planning. A mathematical algorithm could work the numbers and come up with recommendations. Planners would get nowhere if they started with complex spreadsheets, risk return analysis, and Sharpe and Beta ratios. They may impress their client with their financial modelling skills, but will lose the client’s loyalty and business eventually because they did not help him accomplish what he really wanted out of his money.

I am not undermining the technicality and complexity of financial planning. The science behind financial planning sometimes brings even an impossible plan to fruition. In an era of complicated products, high human longevity, early retirement, increasing inflation and low return on investments, a planner must be skilful enough to help the client make the right portfolio choices and navigate him carefully through the complicated web of money management. A well-structured financial plan is the bedrock on which the rest of the plan is built on.

Financial planning is about making the choices that lead you to a happy and contented life, not just financially but also emotionally. To get to this happy combination, a planner must use both art and science. The goal of all financial planners is to forge long-term relationships that will last for generations. This is where an adviser earns his place in the sun.

The post The art behind the science of financial planning appeared first on PeakAlpha.

Nassim Taleb’s book The Black Swan is a fascinating read. He writes about uncertainty and our limitations as human beings in taming this uncertainty. We base our world view on what we see, observe and read. We generalise and make predictions based on these observations and interpretations. And yet, one aberration shatters the foundations of our knowledge and we go back to the drawing board all over again.

Taleb was a finance professor, writer and former Wall Street trader. He outlines a black swan event as an outlier, which “lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility”. He argued that though black swan events are low frequency, they are high impact and almost impossible to predict. Because of their tremendous consequences, people must factor such events to occur in the future, and plan for them. The financial crisis of 2008 and the dot-com bubble of 2000 are examples. So how should we protect ourselves from their impact?

The answer: asset allocation, the most critical decision-making weapon you have in your arsenal to fight such catastrophic events. Sadly, most of us do not use it until it is too late. Not only does asset allocation cushion you against black swan events, it also protects you against normal volatilities of the market.

Asset allocation is about having the right proportion of various assets in your portfolio, which react differently to different market events. When some investments fall, others go up, so your overall returns average out. It helps diversify assets across different investment classes, which have a low correlation with each other, so when one or more of them is badly affected, the others stay constant or rise to keep the overall portfolio afloat.

Apportioning your wealth among different asset classes and rebalancing is a powerful way to ensure you stay the course without getting swayed by emotions. It offers you a much better decision-making framework than ad hoc investing or investing only in specific asset classes.

The right allocation matches your return expectations to your risk profile. It matches your goals to your portfolio and balances growth with stability. Hence, every rupee invested is tagged to a purpose.

Short-term goals such as paying for fixed annual commitments are best met by short- to medium-term debt investments that strive to match inflation, and which are accessible at short notice. Long-term goals such as creating a retirement corpus are best met through assets like equity. Equity beats inflation comfortably but is risky over the short term.

Each portfolio needs to strike the right balance between equity and debt. Asset allocation ensures that neither risky nor conservative investments dominate, and that you systematically trim down the overall risk or safety whenever required.

Rebalancing accomplishes key behavioural changes—sticking to your goal and being disciplined in your investment behaviour. Your goal is your target portfolio ratio. This could range based on your age, risk appetite and goals.  Also, you are forced into the discipline of reviewing your portfolio each quarter, selling what you have too much of and buying what you have too little of.

Through a combination of target setting and portfolio discipline, investors are less susceptible to market noises and thus make rational decisions. Asset allocation highlights the difference between what seemingly rational people should do and what they actually do in times of market extremes. Even though rebalancing involves apportioning assets between cash, bonds and stocks, it is admittedly difficult to enforce because of our psychological biases. Investors tend to hold on to an equity-heavy portfolio when the markets are high, and desist from investing in stocks when the markets are low. Such behaviour clearly explains why investors experienced negative returns long after the crash of 2008. Those investors who sold equity when the markets soared and continued to invest through the lows from 2008 were rewarded with high double-digit returns.

Making money in the long run is not so much about picking the right instruments. In fact, if you are not qualified to do so, you must refrain from such activities. It’s also not about determining your own asset allocation. In reality, more important matters will take precedence, and you will ultimately fall prey to what 90% of us are victims of—emotions, biases and lethargy. If you want membership into the 10% guild, sign up for the niche AA (Asset Allocation) club. There’s nothing anonymous about this club and it’s one addiction you wouldn’t want to get rid of!

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