Many of you buy investment products because they offer attractive features such as high returns or tax-exempt income. Your choice could range from buying broker-recommended stocks to new fund offerings and bond issues rated highly by analysts. In this article, we discuss why you should not buy products just because they carry attractive features! Rather, your first step should be to shortlist investments that align with your investment horizon and then analyse the shortlisted investments for their attractive features.

Bond mapping

Suppose your investment horizon is six years. If you buy bond mutual funds, you will have to redeem your units after six years. Your redemption value will depend on the market value of the bond portfolio held by the fund. If bond prices decline, your redemption value will decline as well! You are, therefore, exposed to bond market risk. Besides, you have to pay taxes on income and capital-gains arising from such investments.

To avoid taxes, suppose you invest in 10-year tax-free bonds issued by government institutions such as NHAI and IRFC. Such investments save taxes but expose you to the same market risk because you have to sell your bonds at the end of 6 years!

You will face a different problem if you invest in a 10-year bond when your investment horizon is 12 years! Then, you will have to reinvest the redemption proceeds received after 10 years into another bond and hold that bond for two more years. If interest rates were to decline in year 10, you will earn lower returns in years 11 and 12.

One way to moderate the risks associated with bonds is to map your investments with your investment horizon. Given that your investment horizon is six years, you should look for an attractive bond investment with a maturity of six years. This means you will avoid investing in 10-year tax-free bonds or a bond fund that has earned high returns in the past!

Equity mapping

Unlike bonds, stocks do not have a finite life. So, mapping equity investments refers to your decision to take profits based on your investment horizon. If you do not align your equity investments with your investment horizon, you will be tempted to take profits whenever unrealised gains are high. And because generating continual gains from market timing is difficult, you are likely to suffer from two behavioural biases- regret bias and disposition effect.

Regret bias refers to the behaviour that you could move away from equity investments, driven by regret that your previous profit-taking decisions were wrong! Disposition effect refers to the tendency to hold on to loss-making positions for too long and to sell profit-making positions too quickly! Suffice it to say that both these biases could lead to failure in achieving your investment objectives.

If you were to hold your investments till the end of your investment horizon, you will not be tempted to take short-term profits. You can moderate the biases by adopting the following rules: One, buy-and-hold investments till the end of the investment horizon. Two, review the investments every six months. If the unrealised gain is higher than the annualised return required to achieve the investment objective, sell investments to capture only the excess returns. Three, invest the excess returns in short-term deposits. Four, transfer this excess returns back to equity to bridge the gap if in any year the unrealised return is lower than the annualised required return.

Conclusion

Mapping your product choices with your investment horizon creates investment discipline; it reminds you that investing is not about chasing “returns” but about achieving objectives! This process, hence, prevents you from buying products that may not be appropriate for achieving your investment objectives, even if they carry attractive features such as high returns, lower fees or tax-exempt income.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. Feedback may be sent to knowledge@thehindu.co.in )

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