Three financial planning mistakes experts make

Your financial plan should not be based on slogans or catchphrases. Instead, keep asking why till you agree with the rationale behind your plan

Let us examine three financial planning mistakes that even relatively knowledgeable advisors and clients are prone to make. Each of these mistakes comes with its own slogan or catchphrase.
 

Personal finance: More personal than finance
 

This slogan “personal finance is more personal than it is finance” is used to justify investing one’s entire net worth in exciting, but high-fee and risky, investments such as active mutual funds (MFs) and portfolio management services (PMS), instead of investing in low-fee and less risky passive index funds.
 

First, the term personal finance is intended to distinguish this branch from corporate finance. It does not mean that finance changes from person to person.

Second, on investing, finance theory says that everyone should diversify and minimise investment costs. This is true for everyone’s personal portfolio — even mutual fund managers.
 

Third, William Sharpe, who won the Nobel prize for the capital asset pricing model of investing, calls de-cumulation (withdrawal post-retirement) the hardest problem in finance. He means that the mathematics in personal finance is difficult.
 

The takeaway is that personal finance is a science based on data and mathematics. Decisions should not be based on feelings, such as optimism or pessimism about the stock market or specific investment products.  
 

Core and satellite portfolio
 

This catchphrase targets investors who suspect that high-fee and very risky products might harm them. The sales pitch is typically that the investor should put two-thirds of the portfolio in passive index funds (the core portfolio) and one-third in high-fee and risky products (satellite portfolio). The sales pitch claims that finance theory supports this approach and will help investors earn a higher return than the index.
 

First, finance theory completely rejects this approach.
 

Second, S&P’s latest (June 2023) SPIVA India report shows that from the inception of clear MF categories five years ago, only 7 per cent of active largecap MFs have beaten the index. While the results show that about 62 per cent of mid and smallcap funds have outperformed the benchmark over the past five years, a point to note is that since S&P did not have sufficient data points for mid and smallcap funds, they had to combine the two categories, which makes the results unreliable. Also, different time periods show opposite results (only 22 per cent of these funds have outperformed over the one-year period).
 

Also bear in mind the risk: the smallcap 250 index fell 37 per cent more than the largecap index in 2008-09, so no one should have a large allocation to smallcaps.
 

The 4 per cent rule
 

The 4 per cent rule claims that a person who has completely stopped working and wants their net worth to last for 30 years requires a net worth equal to 25 times their annual expenses. It also claims that their standard of living each year will not be impacted by the performance of their equity and fixed-income investments.
 

The ‘4 per cent rule’ is just a rule of thumb. It assumes that taxes do not exist. Even if that were magically true, the 4 per cent rule has failed in many countries. There is no guarantee that equity will beat inflation over our particular 30 years of retirement. So, we must conservatively assume that the post-tax return from the portfolio over our lifetime might be in the ballpark of inflation. This would mean our portfolio may not grow in purchasing power terms. Once we stop working completely, we will be consuming our principal. Hence, a person requires a net worth equal to 30 times their annual expenses. Further, the standard of living the person can afford each year will fluctuate significantly based on the performance of her equity and fixed-income investments.


The writer is an hourly-fee financial planner and a Sebi RIA at Fiduciaries.in. He was a private-equity investor for 12 years