Financial Planning & Wealth creation – Dealing with Biases & a misaligned incentive system

January 10, 2025

·     In a country with a large population we are obsessed with “kitna mileage deti hai” and are hard-wired to extract maximum output from limited available resources. Accordingly, for most people Wealth creation often boils down to focusing on extracting maximum returns from existing investments. 0

·     Unlike engineering solutions which can be optimized for maximum output with limited tradeoffs known beforehand, in Investment field higher expected returns by design are accompanied with higher expected risks which could mean higher volatility and even risk of total loss. While most investors are aware of this, a very few Investors are truly mindful of this aspect.

·     For Wealth creation all aspects of the equation  W=(I-E)*(1+r)^n (I=Income, E=Expense, R= Returns, N= Time for compounding.) are equally important rather than focusing on just the returns part. Infact, putting undue pressure on Returns to make good shortcoming in other aspects can be detrimental to Financial health due to the elements of associated higher risks.

·     What is critical is for Individual to have a wholistic approach to planning for Financial goals which could be lifestyle aspirations, Financial Independence, Kids Education, Charity in which all  variables of Budget (Income & Expense), Asset allocation, Insurance planning, Contingency planning, Estate and legacy planning are factored based on Individual needs and risk appetite.

·     However, most people focus purely on returns part and are still fixated on discovering that next investment idea/hot stock tip which will get them through the finish line without getting into the hassles of working out the math.

·     This tendency is exploited by market participants who may be indifferent/generic in their advise to Individual at best and detrimental to financial health of the Individual at worst by peddling products which give them higher commission rather than being well suited for Individuals needs.

·     The issue is further aggravated since the ‘Conflict of Interest’ and ‘Hidden costs’ of such agents are not very apparent to an average Investor. A simple case is that of Direct vs Regular plan. Most Regular plans are sold with the misleading statements that the commission the agent would be charging would be from the AMC and not from the Individual. The fact that the NAV for Regular plans (vs Direct plans) takes a hit due to this higher commission/costs and it is effectively the Investor who is bearing the cost (and not the AMC) is conveniently not mentioned

·     Further such costs are not easily quantifiable by Investor and since it is not a cash outgo but deducted out of Investment made, the inertia to pay is bypassed in this model. For eg Regular NAV of a reputed Small cap fund moved from Rs 17.2 to Rs 204 from 2013 to 2024. Direct NAV of same small cap fund moved from Rs 17.6 to Rs 223. Rs 10 lakhs invested in 2013 would have compounded to Rs 1.15 crs in Regular plan and to Rs 1.27 crs in Direct plan, a healthy difference of 10%. When compounded over larger amounts and periods, the quantum can be staggering.

·     Products which bear higher risks would typically have higher distributor commissions and hence the propensity to sell these products to investors is high.

·     What is necessary is for Investors to hire a financial planner who doesn’t derive any commission from products sold to Investor and works solely in Investor interest *ased on Individual need, not just across equity but debt, insurance, contingency and estate planning.

·     However, psychologically Individuals have a huge inertia to pay a nominal fee of Rs 25,000 but unknowingly shell out lakhs when the same is not apparent to them (through NAV deductions). This has resulted in a highly skewed financial market with majority agents being distributors and very few pure Fee based Financial advisors working purely in interest of client.

·     As Charlie munger says if you have dumb incentive systems you have dumb outcomes. Its time to rethink in our individual interest to move away from system which is not aligned to individual interests of an investor.