Responsible (And Therefore Unpopular) Answers To Frequently Asked Questions From Clients

A considerable part of my job as a financial planner involves giving honest, logical answers to questions clients ask. I firmly believe my job is to tell clients what they need to hear and not what they want to. I therefore prefer to remain responsible with my answers to their questions. Needless to say such answers rarely go down well with my clients (at least on first hearing). But every responsible answer is always backed by logic. And today I will throw light on the logic behind my answers to popular questions I get asked by clients.

Why Can't I Hold More Than 60% In Equity For My Long Term Goals?

This is a question that I get from two categories of clients. One would be those who are single, have no financial dependents and sufficient liquid savings available. The other would be those who have been assessed to have an aggressive risk profile. Both categories therefore have enough cause to ask this question. But I never recommend having an allocation beyond 60% to equity. Let me explain why.

I will first show why an aggressive risk profile is not a license to have an overly aggressive allocation to equity. Individuals with the capacity to take a high degree of risk and the willingness to tolerate it are said to have an aggressive risk profile. It is firstly very hard to define the term 'high degree of risk'. The term is subjective in its very nature. But let us ignore this fact for the purpose of this discussion. The inference of the aggressive risk profile usually comes off the back of the outcome of a risk profile assessment.

Responses to risk profiling tools can never give planners a holistic understanding of a client’s risk profile. They only show the client’s perceptions of risk in light of prevailing events at that point of time. For example, an otherwise risk averse investor may portray a strong tolerance for risk if they are responding at the peak of a bull market. Also, the client can think before responding. There is therefore a possibility that they may not be completely honest with their responses.

Therefore, reliance on such tools must be reduced. I only carry out a risk profile assessment to comply with regulatory requirements. The best way to understand a client's risk profile would be to observe their investment behaviour over a period of time. Especially over the entirety of a bear market. It is only after this that an informed decision can be taken on a client's risk profile. Therefore I never recommend an aggressive allocation to equity purely based on a risk profile assessment.

Now we come to those who are single with no dependents and adequate liquid savings. Most such clients are those who are in their mid to late 20s. And they are relatively early in their journey with equity and other market linked instruments. They are also unlikely to have seen a genuine market crash and bear market. Their standard answer when I bring this up is that they have seen and lived through the 'Covid crash'. The drop during Covid was not a crash in the first place. It was only a steep correction. An actual market crash is entirely different.

During such periods portfolios first drop by 40-50% (if not more). They then remain largely stagnant and go nowhere. Such periods of stagnancy may go on for a few years. This is very likely to be too hard for such young investors to deal with psychologically. This reduces their chances of being able to live with significant equity allocations. This defeats the purpose of having them in the first place. I therefore refrain from recommending anything beyond 60% of the portfolio being in equity here too.

Won't International Exposure Boost Returns?

This is a question I get from a wide variety of clients. The prospect of international exposure in the portfolio is definitely enticing. It does offer clear benefits as shown below.

But international exposure in itself cannot guarantee a boost in returns. In fact, in most cases it slightly reduces returns. Let us understand this with an example. Assume an investor has a 60:40 allocation to domestic equity and debt. Assume post tax returns from domestic equity and debt to be 9% and 7% respectively. The post tax return on the overall portfolio would then be as shown in the graphic that follows.

Now assume the investor adds a component of US equity to this portfolio with an allocation of 10%. Assume the overall portfolio allocation of 60% to equity and 40% to debt is maintained. In such a case, the composition of the portfolio now becomes 50% Indian equity, 10% US equity and 40% Indian debt. A realistic long term post tax return assumption from equity anywhere across the world would be headline inflation + 3%. Headline inflation in America is currently around 2.3%. Therefore a realistic post tax assumption from US equity would be 5.3%. In this case the overall portfolio return would be as given in the graphic that follows.

It is clear from both the graphics above that the return from the portfolio with pure domestic equity is marginally higher. There is of course a case to be made that a higher allocation to overseas equity would bridge the gap. But in doing so the portfolio may be exposed to a greater degree of exchange rate risk. Portfolio costs are also likely to be higher. Any incremental return would therefore likely be eaten away by these factors. Therefore an allocation of anything more than than 10% of the overall portfolio to overseas equity is not advisable. Therefore, investing in overseas equity need not necessarily boost portfolio returns.

Also, the fundamental basis of investment is consumption. In other words, we invest to consume. The achievement of each of our financial goals allows us to consume something. For example when we invest to buy a house or vehicle, we invest to be able to buy the asset in question. We can then make use of that particular asset, resulting in consumption. When we invest in our children’s education, we invest to consume a service (namely education) in the future. And when we invest for retirement, we invest to consume the lifestyle of our choice in the future for a certain number of years into the future.

Therefore our investments must primarily be held in the geographical region where most of our future consumption is likely to take place. Most of my clients who show an interest in gaining international exposure plan to consume mostly or entirely in India. There is hence no fundamental need for international exposure in their portfolios.

Why Are We Expecting My Portfolio To Only Match Inflation? Shouldn't We Aim To Beat Inflation?

I adhere to the assertion of Zero Real Returns when carrying out financial planning calculations. The assertion states that post tax portfolio returns over our lifetimes would be equal to inflation. It therefore negates the need to assume inflation and investment returns. Calculations for all major aspects of the plan are repeated once a year with fresh figures for all key inputs.

But the assertion of zero real returns also states that investors should only expect their portfolios to match inflation on a post tax basis over their lifetimes. I therefore ask my clients to do the same. Naturally this piece of advice is often met with skepticism. Some are even forthright enough to call the assertion of zero real returns overly conservative. Allow me to show why it is anything but overly conservative. Beating inflation post taxes and inflation over the long term requires each of the following conditions to ring true :

1. The investor is rational and never becomes overly greedy or fearful.

2. The investor does not commit any unforced investment errors throughout their journey.

3. The investor does not face a prolonged bear market or market crash for the entirety of their post retirement period.

These assumptions rarely turn out to be true in the real world. Therefore it is virtually certain that real returns (returns post taxes and inflation) would be lower than expected. But it would be hard to precisely estimate the quantum of the reduction. It would hence be prudent to assume that our portfolios would only match inflation post tax over the course of our lifetimes.

Do I Really Need This Much Health Insurance?

For any major city in India, the ideal coverage amount advisable would be Rs 20 lakh per member of a family. This equates to a total coverage of Rs 60 lakh for a family of three and Rs 80 lakh for a family of four. This represents the amount of coverage required in one's personal capacity. It can be purchased as a combination of a base and super top up policies.

The numbers mentioned above may seem unreasonably high. A lot of my clients express surprise and shock when I mention these numbers to them. This is more so because they usually have existing corporate coverage. But there is good reason behind such an amount being advisable. Let me explain. Firstly corporate health insurance coverage doesn't usually continue if the individual's employment is terminated. So it is not completely reliable.

We must also remember what the essential benefit of health insurance is. It protects our income against the risk of paying hefty medical bills. It is therefore a tool aimed at risk management. Managing risk is extremely challenging. This is because most events are dynamic. Unfavourable situations can crop up at any time. And we usually get very little time to respond to them. Risk management must therefore be built into the way we plan for events and respond to them. In other words we must be prepared for negative outcomes, even though we don’t expect them to happen. Effective risk management must enable us to effectively resist the adverse consequences of negative outcomes.

Risk remains manageable most of the time, but not always. And we have no way of knowing whether or not a particular risk is manageable in advance. This is no different when it comes to health insurance. We don't buy health insurance because we expect to develop major health issues that require hospitalisation. We buy it so that we are prepared beforehand in the event of such a situation arising. We also come across situations where the available coverage is insufficient to meet the cost of a particular bill. This is a major risk.

Buying a health insurance policy with a substantial coverage amount covers this very risk. It virtually bulletproofs us against medical costs. Those who have each of the following are less likely to be impacted by healthcare costs.

The first 4 points mentioned above fundamentally reduce the risk of contracting major health issues. The last one allows us to absorb the impact of significant healthcare costs without compromising financial stability. But our personal and professional lives today are very demanding. We may therefore lack the time and/or willingness to adhere to the first 4 points. And it would take most of us a very long time to satisfy the fifth. Therefore buying substantial health insurance coverage proves to be the most viable way to guard against ever increasing healthcare costs.

Closing Thoughts

I am fully aware that some readers (if not most) may still find my way of approaching the answers to these questions quite conservative. But as I have mentioned before, the nature of my job requires me to be responsible with my answers to clients. And there is a golden rule when it comes to answers regarding most things in personal finance :

Responsible answers are never popular, popular answers are never responsible.

As a planner my job is to ensure my clients don't lose money, avoid serious financial errors and have the best chance of achieving their goals. Not to ensure that they become millionaires and billionaires overnight. I would always be okay with clients saying "I achieved my goals, but we could have made more money" in hindsight. But I would never be okay with them saying anything to the effect of "Your advice irreversibly damaged my financial wellbeing." Feedback like that would amount to my failure as a planner. So I would always remain responsible with my answers. Even if it affects my popularity with existing or potential clients. All my clients understand this. And it is something that anyone wanting to work with me should also understand.