Why chase return on investment when you should focus on financial goals
Chasing return on investment without knowing your subtle subjective issues of life is futile for your financial health.
You have responsibilities and commitments towards your family. You know your aspirations of life. You wish to fulfill all your financial commitments within your working period (earning phase). People ponder that they can work till they exit from their profession. If you’re a professional, you are free & may work till your last breath. But contemplate your personal factors like health, family etc. and pre-define your retirement age. If you’re in an employment, your retirement date is pre-defined. But due to unavoidable circumstances, you may have to pre-pone or postpone your retirement. Therefore, time is one of the imperative factors, while you plan to achieve your financial goals / aspirations.
As Certified Financial Planner in Kolkata, we believe that the target/goal amount of gross wealth that you can potentially build up typically depends on:
- Life style;
- Objectives
- The return on investment;
- Investment time horizon (The length of time that you allow your savings to grow);
- Macro economic conditions;
- Your risk profile;
- Income graph;
- Personal factors like health, educational back ground, skill etc.;
- Cash flow;
- Net worth; etc.
Chasing Return on Investment will not serve your purpose
If you chase only one factor, i.e. return on investment without considering the above remaining relative factors, returns will be an illusion. Among the above factors, I think “Investment Time Horizon” is one of the key factors. In personal finance the time value of money means money’s potential to grow in value with time. It’s my observation that some of the investors postpone investment. Delaying investments can cost you enormously since you cannot fully utilize the “power of compounding.”
Focusing only on return on investment will not make you achieve you targets smoothly
M. Scott Peck once said, “Until you value yourself, you will not value your time. Until you value your time, you will not do anything with it.”
As SEBI Registered Investment Advisor in Kolkata, we strongly advocate that the most fortunate part of investments is that you should know what you want to achieve and when you have to achieve. But unfortunate part is that you fail to determine the comfortable “inflation adjusted target return” and “income tax adjusted amount”- the number! Have you ever quantified the amount you require after adjusting those impacts?
Before you think of Return on Investment, consider the length of time over which an investment is made or held before you liquidate (investment time horizon). While you consider return on investment, it depends on portfolio composition, investment objective, your personal factors, the amount you invest, how much risk you’re ready to take, your capacity to take risk, time horizon of investment, prevalent market scenarios, etc. These factors enable you to decide the return you can expect from the investment.
As Financial Consultant in Kolkata, we have seen that you get bogged down, while you only chase market return and the market crashes due to macroeconomic factors. You end up stopping investments before reaching the target amount. Without knowing personal factors like time horizon, target amount, risk profile, etc. you become victim of emotions, like greed and fear.
Without knowing much about your investment objectives or other factors, if you only chase return on investment, you are no better than a reckless driver. If an investor behaves like a trader( who follows only return) he will mess up trying to time the market i.e. entering when the market is high and exiting at loss in search of next performer to reach the break-even point.
Factors to be considered while evaluating Return on Investment
Apart from time factor, you must know your risk profile -It’s an evaluation of an individual’s willingness to take risks and ability to take risks. A risk profile is important for determining a proper investment asset allocation for a portfolio. You have to set your goals and quantify the goal amount by questioning ‘how much?’. You must move ahead keeping in mind investment time horizon and expected return on investment by considering deviations. It must be noted that deviations are minimum in the long run. Standard deviation, beta, alpha, other financial ratios can be useful tools for investors like you while you look for the risk and volatility of a particular investment/portfolio.
While, we write financial plans for our clients, we focus on their aspirations. While we make investment strategies as per financial plan, we always give stress on risk profile. It can’t be ignored as risk profile is a process for finding optimal level of investment risk for my clients by considering risk require, risk capacity and risk tolerance.
Risk required, risk appetite and risk tolerance are financial features. It’s used for psychological characteristics of my clients and can be determined by a way of a psychometric test.
As Financial Advisor in Kolkata, we have to assess each of these characteristics separately and compare with the other. Risk taking capacity and risk tolerance both act separately as constraints on what my clients might otherwise do to reach their goals/aspirations (risk required).
It is unusual for a client to be able to achieve their goals from the resources available within both their risk capacity and risk tolerance.
If there’s a mismatch between risk required, risk capacity and risk tolerance, our role is to guide our clients through the trade-off with informed decisions that are required to reach an optimal situation. Therefore, developing informed decision making ability requires financial counseling.
The risk profiling process is nothing but the client has to understand the risk and return expectations so that we can advise our clients. Our clients understand and agree to implement the investment strategies. Everything is process-oriented.
Finally, the risk profiling process means nothing but to ensure our clients that they have realistic risk and return expectations. We can guide our clients in a fiduciary capacity and our clients are properly informed. They give their consents to implement the investment strategies.
Chasing only return on investment can prove to be fatal
Let’s have a live example (I’ve changed the name due to confidentiality clause) for better understanding:
Mrs. Bagchi has Rs. 34 lakhs in mutual funds and plans to retire at 55. Apart from this, she believes she can invest further of Rs. 13.35 lakhs every year for further next 10 years to reach her retirement goal. As per her current life style, she needs a retirement corpus of Rs. 3.30 crores if she survives till the age of 75.
She thinks she’ll be comfortable with equity exposure, that too 100%. Mrs. Bagchi thinks of the average rate return, twice the rate from bank fixed deposits. But she’s not aware that any fall in value would make her uncomfortable, i.e. she’ll hardly tolerate any deviation from the mean return. We’ll assume she can afford to live with the volatility, unless we know her risk tolerance capacity.
By considering her risk tolerance capacity, she may invest maximum 50% in growth/high risk schemes and rest in low risk schemes. Where, she can expect a weighted return of 10.25%.
The next question is, whether she can achieve the target amount, i.e. Rs. 3.30 crores over next 10 years if she continues her existing portfolios and also invests the fresh additional surplus money every year as per her risk profile. Yes, she can reach the target amount.
Conclusion
To conclude, when you make your investment strategies try to consider all the factors, not just the return on investment which I have discussed. It’s better not to invest haphazardly. First make a Financial Plan, and then implement the plan with periodical reviews. Your investment strategy of chasing return or trying to time the market, is next to impossible. In any investment there is risk, may be Unique + Market or only Market risk. Know the types of risks associated with investments. While you understand the fundamental concepts behind each type of risk, you’re able to take informed decisions with great confidence.
Therefore, chasing only return on an investment without knowing all the parameters, do more harm than good. While you unknowingly or knowingly chase higher return, you take higher risk and sometimes you can’t tolerate deviations, thus you sell your investments at a loss. Ultimately, you don’t enjoy the journey and end up with distress.
If you fail to do it yourself, consult with a qualified personal finance professional, who’ll act for you in a fiduciary capacity.
