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Email : contact@wisdom2wealth.co.in 
Life is full of uncertainties and managing your investments is no exception.
All of us would like to be successful in managing our finances better - whether it is by regularly earning a high level of income, or by keeping a tab on our expenses in the future, or by investing appropriately to achieve future financial goals, or by keeping our liabilities in check. However, many of us may not be aware of the various issues involved at different stages of this journey, let alone being familiar with how to successfully navigate through them.
Given below are some important pointers that you should be aware of, so that you can successfully find your way through the investment management maze.
There is no alternative to having a disciplined approach in managing your finances.
You need to have the discipline not to spend more than what you earn; the discipline to regularly invest a high proportion of your income right from a very young age; the discipline not to sell off your investments prematurely to spend on impulsive buying of luxury items etc.
Often, despite earning a high level of income, people end up in a financial mess. This is either because they lack the discipline to invest regularly for future financial goals, or because they don’t keep a strict control on their expenses and ultimately end up borrowing instead.
For example, would you treat your annual salary increments / performance bonuses / windfall gains (e.g. lottery winnings etc.) differently from your regular monthly income? Do you think it is okay to spend it as this is ‘additional’ money you have received that is not required to meet your financial goals? If you do, you may want to know that it is now well established that those who receive such windfall gains are no better off financially a few weeks / months after receiving the gains than they were just before. Instead of spending a significant proportion of such additional money, you should be investing it as if it is your regular income. Such a discipline will help you achieve your financial goals earlier and with greater certainty.
Bottomline – If there is one attribute you must develop to be successful in managing your finances, that is to have the discipline in all aspects of money management.
Different types of investments are exposed to different levels of ‘risk’. For example, you may not get the expected investment returns, or in extreme circumstances, may even lose the entire amount you have invested.
Given this, higher the risks involved in any investment, higher should be the investment returns offered. But how should you select between two investments with different levels of risks and investment returns?
There are several methods to measure the relative attractiveness of two investments. For example, in case of equity investments, you could consider statistical measures such as the ‘standard deviation’ of investment returns, the ‘Sharpe’ ratio, the ‘Beta’ of the stock, the ‘value-at-risk’ (VaR) etc. between two equity investments.
Don’t worry - we are not discussing what each of these measures mean or how they are derived. However, you should understand that when selecting an investment, you should aim to maximise not the absolute level of investment return, but the investment return that is adjusted for underlying risks (i.e. the ‘risk adjusted return’). In other words, whilst selecting an investment, you should be aiming to maximise the ratio of ‘return’ over ‘risk’ of the investment.
How should one think about these ‘returns’ and ‘risks’ involved in an investment?
Such historical statistical data pertaining to various investments is regularly published by investment analysts / stock exchanges etc. so that when selecting an investment, you may be able to take an informed decision.
How much should you rely on such historical data?
Historical data alone may not be a good indicator of the expected investment returns and risks that may arise in the future. Just because an investment delivered X% return in the past may not mean that it will definitely deliver the same return in the future.
There are several factors that may have an impact on the future returns in any investment – e.g. changes in the level of interest rates in the economy, the stage of business cycle that the given company / industry is in, changes in taxation regime etc.
For example, if over the long-term, the equity investments are expected to deliver a return of say 13% p.a., and over the past several years, the cumulative returns have been around 18% p.a., there is a good chance that for the following years, the returns may be lower than 13% p.a. A company / industry typically faces business cycles (periods of high growth / profitability, followed by low growth / profitability) and hence, the investment returns as reflected in its share price movements continue to change based on the stage of the business cycle the given company / industry is in.
Hence, it may not be appropriate to be overly reliant on the historical data. In taking investment decisions, you should really be considering what may happen in the future – the guidance for which may be provided by the company itself and can be analysed by your investment advisors / analysts.
Would such a guidance help you invest at the right time so that you can maximise your future returns?
You should be aware that the internal managements of companies will always know more about their businesses than the owners of those companies (i.e. the shareholders / investors like you). In other words, there will always be information asymmetry between the ‘insiders’ (i.e. the senior managements) and the ‘outsiders’ (i.e. the investors).
Although there are laws in place that prevent buying / selling (i.e. trading) of shares based on insider information that is not publicly available, in reality, such instances of ‘insider trading’ exist. As a result, taking investment decisions based on guidance provided by the companies may not always provide opportunities to maximise your investment returns.
This also means that over the long-term, an individual investor can never earn an investment return (other than by pure luck) that is consistently higher than the return that would be earned by the market as a whole. This is simply because an individual may not have the access to or the ability to use the ‘insider information’ (even if this was legally permissible) that would drive the market prices of the investments before anybody else acts on the same.
In other words, trying to ‘time the market’ (i.e. buying a share just before the market price increases and selling just before the market price decreases) is futile. An individual investor cannot accurately and consistently predict the market price movements, especially when there exists such information asymmetry.
Given that you - an individual investor - may not have the necessary information or the skillsets to maximise investment returns on your investments, would it be better to allow external investment managers (e.g. banks, portfolio managers, mutual funds, insurance companies etc.) to do the same?
‘Agency cost’ is not referring to the commission charged by an agent or the fees charged by the external fund managers. What this is referring to is the existence of costs (resulting in the possibility of a lower investment return) associated with the ‘principal- agency’ relationship in economic sense.
The ‘principal-agency’ relationship arises because those who own the investments (i.e. the shareholders / investors, i.e. the ‘principal’) are not the day-to-day decision makers (i.e. managers / investment managers, i.e. the ‘agent’) in respect of the same. Given that the ‘agents’ aren’t the owners, they may not be diligent enough in managing the investments of the ‘principals’, which may result in the ‘agency cost’.
The interests of the investors (e.g. maximising the profits, maximising investment returns, sustainably over the long-term) may not be aligned with the interests of the managers / investment managers (e.g. maximising business growth in the short-term, so as to get high bonuses and promotions; or maximising the management fees etc.). Thus, the decisions taken by such external fund managers may not always be in the best interest of the investor.
You may not be able to eliminate such agency costs completely. So what can you do?
Given that you may not be able to eliminate such agency costs completely, should you, then, select a manager / investment manager that charges low price / fees so that you can maximise your investment returns?
Should you always select investments / investment managers based on who has the lowest ‘price’ / charges the lowest fees, and therefore is expected to deliver the highest returns? Not really!
At times, companies / investment managers may lure investors by offering low prices / fees, but may fail to deliver good investment returns sustainably over the long-term, simply because the price / fees charged may not be sufficient for them to attract and retain good quality professional managers. This, in turn, may lead to lower growth / profitability / valuation of the underlying investments and lower returns for you. Thus, despite paying a ‘low price’ for your investment, your may not be able to maximise your investment returns in the long-term.
Given that you shouldn’t select investments / managers only based on the price / fees charged, you should aim to look out for ‘signals’ that are indicative of the likely high quality of the company’s managers / investment manager. This is similar to you getting warranties from the consumer goods (e.g. television, cars etc.) manufacturers who want to communicate to you about the high quality of their goods and justify the high prices charged by them.
Examples of such signals include:
Given all such uncertainties about future investment returns, you may be attracted to the guarantees provided by the investment managers.
However, you should be aware that if the investment manager is prepared to give a guarantee, he is taking a risk too given that there can be no absolute certainties for anyone - including for the investment manager. Hence, the investment manager providing such guarantees would need to reflect the cost of such guarantees in the price charged, making the investment more expensive for you and your overall investment return lower in the future.
Yes – Relying entirely on the external managers has the issues related to information asymmetry and agency costs described earlier, but seeking guaranteed returns to mitigate the impact of these issues may also not help in maximising your investment returns.
If this all sounds like we are going round in circles in this investment management maze, then we are!
The only way out is for you to be taking full control of your financial matters by investing the time to enhance your knowledge and skills in this area. With experience, you should be able to successfully navigate through these uncertainties and risks, to maximise your investment returns.