Retirement savings myths

Following is an interesting article by Niranjan Rajadhyaksha in www.livemint.com. For those who have not experienced the new finance paper 'mint' in India, we strongly recommend including it in your regular diet:

"Retirement saving myths

The standard portfolio model is flawed because it ignores human capital, according to economist Joseph Stiglitz
Cafe Economics Niranjan Rajadhyaksha

Most of the financial advice we get is hopelessly inadequate and simplistic—if not outright wrong.

Last week, I heard Joseph Stiglitz launch a typically blunt and brilliant attack on some of the sacred cows of the financial advisory business. The economics professor at Columbia University in the US and winner of the 2001 Nobel Prize in economics is popularly known as a trenchant critic of some aspects of globalization, though his academic work spans a wide range of economic issues, including financial ones.

“Long-term financial planning is a very complex task. Individuals cannot judge what they need to do and so they fall prey to wrong advice. This gives rise to fashionable rules of thumb,” said Stiglitz in a presentation at the Second European Colloquia organized by Pioneer Investments in Vienna at the end of November. (Disclosure: I was in Vienna as a guest of Pioneer Investments.)
Most of our value as economic animals resides in our ability to earn over our working lives—our human capital. The most common rule of thumb is that an individual should invest heavily in equities at a young age and then gradually move into bonds as the age of retirement nears. A popular and pseudo-scientific way of defining this rule is as follows: subtract your age from the number 100, and you get your ideal exposure to equities. For example, a 30-year-old should have 70% of his long-term savings in equities (100-30) while a 50-year-old should bring it down to 50%.

Neat, huh? But also wrong, said Stiglitz.

Most financial advice—and the economics that underlies it—is flawed. It assumes that an individual has only two types of capital: relatively safe fixed-income bonds and equities that are more risky but which also give more returns. The question is how long-term savings should be distributed between the two as we age.

“The standard portfolio model ignores other forms of individual capital,” said Stiglitz. One important form of this is human capital, which is usually calculated as the present value of all the future earnings an individual will earn over his working life.
Most of our value as economic animals resides in our ability to earn over our working lives—our human capital. According to some estimates, nearly 80% of an individual’s capital is human capital. This form of capital and its risk profile should ideally be considered while designing a good financial plan for retirement.

Human capital is usually more risky at a young age, points out Stiglitz. You are just starting off on your career and the future is uncertain. As you age and get settled into your chosen profession, the uncertainty about your ability to earn starts declining. Human capital gets less risky as you age.

Seen from this perspective, most financial plans are built on shaky foundations. A 25-year-old setting out down a fresh career path faces huge amounts of risk in his overall portfolio (financial and human), because his future earnings are uncertain. Ideally, his financial portfolio should have low risk to balance out the high risk in his human capital. He should be buying more bonds than he is usually advised to do. But the cookie-cutter financial advice that he gets is to put most of his savings into equities—and increase his overall risk.

The big question is whether human capital resembles a safe bond or risky equity. In a separate presentation, Stephen P. Zeldes, a professor of finance and economics at Columbia University, asked: “Is labour income stock-like or bond-like?” He suggested there are no easy answers here. Without disagreeing with Stiglitz, Zeldes said labour income has both characteristics, depending on the circumstances.

All this makes financial planning a complicated process. Besides, other factors such as which industry one is working in, the nature of one’s family responsibilities and home ownership also need to be thrown into the consideration. In a country such as India, for example, where a large part of the population is self-employed, labour income would tend to be risky.

Perhaps we are wrong in blindly assuming that we should cut our exposure to equities as we age. In fact, a well-settled professional with stable earnings perhaps has more reason to invest in equities than, say, a young entrepreneur in a technology start-up.

These are nuances that are often ignored, even in our grander debates on how pension fund money should be used in India.

One challenge before those involved in designing social security systems is how to balance freedom of choice and good guidance. Choice is important because an individual knows about his retirement needs than outsiders. But, as Stiglitz pointed out, individuals make rational decisions by learning from past experiences—their own and of others. That’s not possible for retirement planning. A person who realizes at 60 that he has not saved enough for his retirement cannot say: “I’ll do better next time.”

There is no second chance.

Your comments are welcome at cafeeconomics@livemint.com"

India Sensex hurting !

Sensex pundits now talk of structural problems, given the dive in the Indian stock market. This was the same bunch talking the Sensex to further highs past 20,000. If you had invested in the index at 20,000, you would be poorer by 7.86% in a very short period of time !

Experts and market analysts are taken aback by today's industrial production growth figures that puts Sept 2007 growth at 6%+ down from 12%+ same time last year. Increasing loan rates, squeezed credibility and higher rupee seem to be weighing heavily on growth indicators - effects of these actions should not be a surprise to anyone!

Sensex is most likely up for a period of volatility. You need to maintain a longer term value-driven view to have the stomach to take this churn. Its like buying a house - you don't check prices every day and don't look to sell quickly. When you buy shares, you are effectively buying ownership into the company - a commitment that is best given some time to bear fruit. If you have selected the company right and bought at appropriate price/value, you could be in for sustainable value creation.

Sensex reaches 20,000 – where is gravity ?

Sensex reached 20000 yesterday (29 October). Only a few weeks ago, we were cheering while being sceptical of the 17000 level ! The following factors seem to have driven the market to this new all time high:

• FII (Foreign Institutional Investors) have 18 months to unwind their participatory note (PN) positions. This has led to many of them staying in the market and not withdrawing in a deluge as was thought
• Domestic Institutional Investors (DII) seem to have got into the buying act this time around
• Corporate earnings continue to be strong
• Sensex PE ratio on a six month forward basis is around 21 times and on a 12 month forward basis is around 19 times. Bulls continue to feel that these are acceptable numbers given runaway valuations in China and expected economic and corporate growth in India. In fact, the famous Indian investor Rakesh Jhunjhunwala who is bullish for the longer term, has expressed little surprise at Sensex reaching this summit.

India market cap is at $ 1.55 trillion while China is at $ 3.6 trillion. This now makes India no. 9 in terms of global market capitalization rankings. This market is now one of the top wealth creators in the world: Sensex has returned 60%+ on a year to date basis. Only China is way ahead at 200% +. While we should rejoice at such wealth creation during the festive Diwali season, some pundits suggest caution. They highlight that:

• 60%+ of the 991 point rise in Sensex between October 15th and 29th has been driven by three stocks: Larsen and Toubro (gained by 25% in this period !), ICICI Bank and Reliance Industries
• If you add the next three top gainers i.e. HDFC, Tata Steel and HDFC Bank, you can account for 80% of the recent rise in Sensex
• Bharti Airtel, Infosys and Reliance Energy, who were the drivers of another recent rally, declined by 213.13 points in this period
• FII may unwind as they get closer to the 18 month deadline. Question remains on who would take up the slack in such a case.

Given the meteoric rise of the Sensex, retail investors seem to be jumping in so as to not miss the action. Do remember though, a retreat of Sensex from 20000 to 19000 would mean a drop in value of 5%, if your portfolio mirrors the index. A 20% drop in value would need the Sensex to be closer to 16,000. This comes back to what you are willing to lose – if 20% is your tolerance, your ability to bet on this rising tide would be that much higher.

Sensex crash: SEBI initiates probe, while some retail investors appear to be back !

SEBI is said to be probing the role of various parties, especially top foreign portfolio investors, in the Sensex collapse of 17 October 2007. The stock market (BSE) crashed by 1700 points within minutes of market opening on the back of relatively small volumes. The regulator seems to suspect that trades may have been done at way off market prices with some of the same investors coming in to buy securities at lower prices when markets reopened after the hour trade was halted for. Issuers of Participatory Notes (PN) seem to be under scrutiny.

Meanwhile, some reports suggest that retail investors did not appear to be hurt very badly in the Sensex crash as many may have booked profits at the high levels. Dealers also feel that investors were hurt more by the US subprime led stock market fall in August than this particular crash. In fact, BSE data seems to suggest that retail investors may have bought Rs 1871.22 crores in last three trading sessions end of last week.

It remains anyone's guess how all this will play out in the short term. Volatility can create both significant gain and severe pain - all depends on your risk appetite !

Indian stock market index Sensex at 17000 - however, you wonder why your portfolio is not following suit !

The T20 world cup has been won, people are ecstatic and roads in Mumbai have been suitably jammed at this afternoon's victory parade. Investment gurus think there is a rising tide of good cheer what with the world cup and Sensex at 17,000. Some of the braver ones talk of 19,000 !

You must be feeling rich if you have stayed with the stock market roller coaster over the last few years. On the other hand, you may be surprised that your portfolio does not necessarily reflect the full impact of this wonderful turn of events.

Some observations, based on market commentators' views:

1. There is a view that foreign institutional investors (FII) are throwing money at emerging markets like India to get away from the sub-prime mortgage mess and lowering interest rates in the US. As we have seen before, this flood can come and go at reasonably short notice ...

2. Rally has been led by large cap stocks this time around. Good for you if you were mirroring the large caps in your portfolio. However, the last rally was mid cap based ! Even better, if you had both sectors covered - if not, you are probably hurting in some areas ...

3. Some suggestion that markets show an overbought position ...

4. Let us get to the 'other hand' of this story. Bulls mention corporate earnings continue to grow robustly, inflation (as measured officially) has been reined in and therefore an ongoing growth in the stock market cannot be ruled out (remember the pundits who talk of 19000) ...

If like many of us, you also cannot time the markets, then a few thoughts for you:

1. Invest on fundamentals of the companies

2. Stay with them for a reasonably long period if you like the firms' business, their management strength and growth story

3. Ride short term price gyrations - provided the firms continue to do well

4. Remain diversified in your portfolio mix.

If you are a novice in stock markets, then consider hiring a professional portfolio manager and / or devour analyst reports regularly so that you can take measured actions.

Good luck !