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Financial planning and asset allocation are based on assumptions. After a family’s risk appetite and goals have been ascertained, allocation between various asset classes such as fixed-income investments, equities and real estate is arrived at. The adequacy of savings and accumulation to fund future requirements such as child’s education or meeting medical expenses or retirement are based on assumptions relating to the returns that can be obtained from the various asset classes over the given investment horizon.

There is wide recognition of wealth creation opportunities from equities as well as the need for a long-term horizon. However, there is no agreement on what is the precise measure of long term. Lack of awareness among investors on account of poor understanding and communication from financial planners causes a lot of avoidable grief. Real-life returns do not necessarily conform to the assumptions made.

Projecting an average return of 15% from equities without giving a range is like saying that the average temperature in a place is a pleasant 22°C without mentioning that the lowest temperature is -5°C and the highest 40°C. It is simply assumed that a systematic investment plan (SIP) and a long-term investment horizon will take care of the volatility. This may turn out to be a simplistic assumption and has numerous shortcomings.

What’s long term? For one, the long term is left undefined. The Income-tax Act specifies a period of 12 months as long term and many financial planners and sales personnel of mutual funds call periods ranging from three to five years as long term. The fact is that this does not stand up to empirical scrutiny. This can be proved both numerically as well as intuitively. Numerically, it can be shown that even a 10-year SIP in the Indian markets starting at various points in time has no assurance of capital protection. If one started an SIP in 1992-1993 at the time of the Harshad Mehta boom (Sensex levels of around 4,200) and the SIP ended in 2002-2003 (where the Sensex was below 3,000) one would be in the negative territory as far as returns go. SIPs started in the heady days of 2007 would not be looking good today.

Even if we look at other countries, we see a similar pattern. The US and a lot of countries in Europe call the period from 2000 to 2010 a lost decade where equities did not give any returns. Japan is an extreme example where there have been multiple lost decades.

I am not trying to scare away investors from equity investing. Far from it. Equities have a lot of potential to create wealth and this asset class cannot be wished away, especially when real interest rates (inflation-adjusted) are either low or negative. What is required is some change in paradigm, some damping of enthusiasm in checking portfolio values and an occasional tactical view of asset allocation.

Equities need longest horizon: Fixed-income investments usually have defined maturity, ranging from a few days to a few years. Equity, on the other hand, has no maturity date. Many investors are comfortable buying seven-year National Savings Certificates, 15-year Public Provident Fund, 30-year institutional bonds and 40-year insurance endowment policies. However, when it comes to equities, they have their portfolios checked frequently and expect virtually instant results.

It is indeed ironical that investors have a long-term approach to short-term instruments and have a short-term approach to the longest of investment alternatives. It can be shown using Indian equities data that the lowest returns from a 20-year SIP has been in excess of 10% per annum, while the range has been between 10% per annum and 20% per annum. This is surely a very satisfactory range and should comfort most investors.

Don’t focus just on returns: Hence, it may be worthwhile framing an asset allocation strategy and sticking with it even if returns do not seem satisfactory over a three-five year period. Further, it may be worthwhile to focus on safety first rather than earning maximum returns. While financial advisers are not expected to be market forecasters or market timers, they should try and avoid bubbles and euphoria, especially when these are concentrated in select sectors. Giving the dotcom boom in 1999-2000 and the real estate/infrastructure boom in 2007 a pass would be among the best advice a financial adviser could have given clients. It is here that occasionally one may need to take a tactical view to asset allocation rather than just following rules mechanically.

Rajeev Thakkar is chief executive officer and director, Parag Parikh Financial Advisory Services Ltd.

Illustration by Shyamal Banerjee/Mint

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