Delayed feedback on investments

It could prompt you to invest less in equity and alter your risk perception

Your biggest personal finance problem is the delayed feedback on your investments. In this article, we discuss how delayed feedback drives your risk perception and asset allocation. We also discuss how to address this issue while creating your goal-based portfolios.

Present bias

You and I suffer from present bias — we prefer smaller gains now than larger gains in the future, even if the latter is better for our financial well-being. This bias affects your decision to invest in growth assets.

Growth assets are investments whose primary source of return is capital appreciation — for example, equity. Bank deposit, in contrast, is a classic example of an income asset. As a working executive, you should prefer growth assets because expected returns are high. But the flip side is the uncertainty in returns.

Suppose you have a 10-year time horizon to achieve a life goal. With equity in your portfolio, you may not know even in the seventh year whether you will achieve your goal after three years. You know the maturity value of a 10-year cumulative deposit at the time of investment. But you will know only at the end of the 10thyear whether your equity investments have paid off or resulted in an investment value-gap (difference between the actual portfolio value and the amount you require to meet your life goal). That is the delayed feedback.

The delayed feedback leads to uncertainty in outcome and higher perceived risk. This could prompt you to invest less in equity — your risk perception can change your asset allocation.

And that could hurt your chances of achieving your goal. Why?

The most important step in your investment process is deciding how much to invest in equity — your asset allocation decision. You should invest in equity if your time horizon for a life goal is more than five years. Further, longer the time horizon for your goal, more should be your exposure to equity. You cannot change the delayed feedback mechanism associated with risky investments such as equity.

Creative cheating

So you should cheat your brain to accept more risk. One way to do so is to hire an investment advisor to arrive at an appropriate asset allocation for each of your life goals. Why?

Letting someone commit a mistake on your behalf causes less regret than committing the mistake yourself. Importantly, your investment advisor, as a behavioural coach, can nudge you to invest in equity despite uncertain outcome.

You can alternatively decide your asset allocation using the floor-upside rule. You have to first arrive at the minimum amount (floor) you need to have in your goal-based portfolio at the end of the time horizon for the goal. For example, you may need a minimum of ₹1.30 crore to buy a house, but your desired house costs ₹2.25 crore. You should invest in bank deposits to create your floor (₹1.3 crore). The upside (₹0.95 crore) comes from equity investments.

Then, you should set up an SIP on an equity fund in your spouse’s name for each goal. That way, your present bias or change in risk perception will not jeopardise your life goals.

The writer is founder of Navera Consulting. Send your feedback to portfolioideas@thehindu.co.in

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