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Thursday, August 9, 2012

Current popular Asset classes Fixed income products may not be the right choice for long term

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Chasing the latest fad is seen not only in fashion, but also in finance. Even in one's finances, we tend to choose the latest, hottest product. So, if colleagues in the office are procuring a particular insurance policy or are going for some investment plan, it becomes the basis of investment itself, without any further thought. Thought is not given as to whether the product is suitable for them in terms of the asset class, duration, liquidity, risk profile of the product, end use and other factors.

 

The other fundamental problem is that different products perform at different times. Fixed income securities give good returns when interest rates peak. But logically, when interest rates peak, economy and it's constituents – the businesses, tend to underperform due to the higher cost of capital.

 

The right time to invest in an asset class which displays up and down cycles is when it is down, not when it is at it's peak. Investors tend to invest when the market is in the middle of a bull frenzy.

 

In case of products which are prone to cycles it is very difficult to divine the bottom point, at which to invest. The psychological aspect comes into play here. When the markets are bottoming out, investors expects it to go down even further. But contrary to expectations when it starts rising, they expect a dip again as the lowest level is their anchor now and anything above that seems expensive.

 

When the price has moved up and away, investors realise that they have missed the boat. They wait even more. When markets move up further and there is a frenzy, investors come in. Soon after, markets tumble as investors have come in at the height of a bull cycle. Then investors retreat into a shell and want to invest only in fixed income products.

 

Investments done when markets are their peak take very longtime to give returns. This happens as we want to time the investments and want to chase only those that are giving good returns, at that point. Paradoxically, we end up getting poor returns when we are gunning for products that give good returns all the time! Chasing returns like this will ensure that one ends up buying equities, real estate, gold etc. at inflated prices, as investors tend to buy when they are performing. Pulling money out from "non-performing assets" like equities now and channeling them into "performing" assets like FD, gold, real estate looks like the path to nirvana. Actually, they are setting themselves up for future failure.

Investing too much into fixed income securities alone also exposes an investor to undue risks. Fixed income products mostly do not give positive inflation adjusted returns. This means investors will have to contribute a larger amount to reach their goals using fixed income products.

Also, staying away from cyclical assets when they are at the bottom of the market would result in investors not enjoying the rewards when the market begins to rise.

 

Investing in products which are doing well at that moment also does not address several other aspects that need to be taken into account while investing.

 

The first is that one needs to know why they are investing in a product – what is the end use for it. Without a proper goal, an investment tends to be fuzzy. A product invested without much thought, may be a long-term one like property, but the requirement may come for it after a year. In such a situation, there is a huge mismatch between the product characteristics and it's end use. Hence, one should at least classify whether a product is for short-term needs or for the long-term goals. That way, one would invest in an appropriately oriented product.

 

Secondly, one needs to invest for an appropriate tenure. Some products offer good returns only over time. Correct tenure for an equity product may be five years.

 

Now, if it is invested for a couple of years and redeemed, it may give poor returns.

 

The other aspect is liquidity. Investing in PPF may be a very good idea for someone who is accumulating a corpus for retirement. However, it may not be suitable if the amount is required for their daughter's admission, two years hence. This is a classic problem. The product may be good in a lot of cases, but may not be useful if it is not properly matched.

 

The simple solution is to diversify one's investment basket. That way, one will not end up with one kind of product alone and lose out on the potential that other products have. The other solution is not timing the investment and investing across cycles and time horizons. If one also rebalances assets and sticks to a predetermined asset allocation, it will work wonders.

 

It requires guts to put in more money into equities at the bottom of the market, like what Warren Buffett did in 2008 and 2009. But, he is no ordinary investor. He does not chase fads. He is after good investment propositions – which he got at the market bottom. Time for us to learn from the master – that buying in times of distress is the correct investment strategy and investing while there is a frenzy is a slippery, glacial slope to nowhere.

 

Moving with the tide may not necessarily be the best option

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