ArchiveJuly 2018

Who was the first goal based financial planner?

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Seneca.

You wouldn’t have thought that, would you?

Do you ask what is the proper limit to wealth?

It is, first, to have what is necessary, and, second, to have what is enough.

 – Seneca

 
 
Seneca was probably the first one to talk about goal based investing. If you desire “wealth beyond measure”, there is no limit to it. You may be the richest person in your street, but there’s someone on the next who’s richer. If you beat him, there’s still someone else. And so it goes. 
How do you turn this unbeatable situation on its head? By saying that you aren’t really competing with anyone else, and all you want to do is fund your own goals. Once you do that, you start coming closer to Seneca in his thoughts. 
 
Another wise man said 
 
“Wit beyond measure is man’s greatest treasure”
Shakespeare.
Not wealth, but wit.

Should you invest your money in a P2P lending scheme?

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The other day someone posted a link to a Peer to Peer (P2P) lending company on a whatsapp group, and asked the members for their opinion on investing in such a scheme.

For those of you who are familiar with the concept of P2P lending, feel free to skip this paragraph. For the uninitiated, let’s first start with banks. Their main function is taking deposits from people, either in the form of cash in your account or fixed deposits. They then loan that money out to people or companies who are looking for funds. They charge the borrowers interest, keep some money for themselves, and pass on the remaining to the depositors. Borrowers get to pay lesser interest if they are putting collateral on the loan (house, vehicle, plant machinery, etc.), or have a proven history of paying back loans on time, and so on. By the same token, depositors get more interest if they are willing to deposit larger sums of money, or deposit it for longer periods of time. And the bank still make its margins.

The banks now have a dangerous task: how do you select those debtors who are more likely to pay their money back, and reward them with a low interest rate? How much interest do you charge a more “risky” debtor, who has a higher probability of defaulting on her loan? And finally, how do you balance out your loan portfolio and ensure that your depositors, who have trusted the bank with their capital, are not exposed to the risk of losing their money?

Thankfully banks have developed complex algorithms to help them decide this. The idea of credit scores, (however faulty) are an important part of this. (There are also slippages like the recent spate of high profile borrowers taking massive chunks of money and running abroad, but this is because the due diligence of the banks being cut short.) At its heart, the reason the system works is because of the economies of scale: banks simply have so many debtors and depositors that they can easily reduce the risk in the loans they are making by simply loaning money to a wide variety of borrowers, who are willing to pay a wide variety of interest rates.

At its heart, the reason the system works is because of the economies of scale: banks simply have so many debtors and depositors that they can easily reduce the risk in the loans they are making by simply loaning money to a wide variety of borrowers, who are willing to pay a wide variety of interest rates.

P2P lenders cut out the bank from this picture. If you are a borrower, your creditworthiness is assessed by the website, and an interest rate is decided for you. If you are an investor, they put the onus of selecting the people whom you want to loan your money to.

The particular website I was browsing requires you to invest atleast Rs. 1 lakh. You can then loan as little as Rs. 1000 to an individual borrower, and make a portfolio of upto 100 loans in this fashion. All of these borrowers would pay you back with interest over the tenure of the loan, which could be from 12 to 36 months.

The website promises returns between 15% and 36% on your money. Sounds fantastic, doesn’t it? Well, you should remember that nothing comes for free in the financial markets. There’s no free lunch! In this case, how do you evaluate the default risk? Lets say that one of your hundred borrowers loses her job. That’s a 1% NPA, (Non Performing Asset) to use current parlance. Do you have the capability to withstand such a loss? If you say yes, read on.

Lets say that there is a systemic downturn in the economy, and the IT industry starts downsizing. If you’ve loaned 50% of your portfolio to people working in IT jobs, you’re staring at a 50% NPA problem.  Do you have the capability to withstand such a loss?

If your answer is “yes, because I am attracted by the outsize returns that this scheme is offering”, you should re-consider if this is investing or speculation for you. Investing is always about protection of capital, and growth of capital over the long term with the hopes of beating inflation. Speculation, or the more dashing Hindi word Satta, is about out-size short term gains with the understanding that the full capital is at risk. Exactly like a bet at the races – you could buy a ticket for Rs. 100 and hope to win Rs. 10000, with the full understanding that you could lose all of your Rs. 100.

In conclusion, should you invest in a P2P lending scheme, or something similar which offers unbelievable returns? First, don’t call it an investment, call it speculation. Second, if you’ve made the choice to speculate, feel free! Remember to restrict the amount you speculate to an sum that you can afford to lose, because it isn’t much different from a lottery. Good luck!

Of cashbacks and digital wallets and mental accounting

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Marketers all over the world earn their salaries when we reach for our wallets more often. Everyone knows the pesky salesman when they see one, and some are even smart enough to evade him all together.

But they’re getting smarter every day. It turns out that we’ve got little bugs which evolution has left behind in us, and it is these bugs that they are exploiting to their benefit!

Let me tell you a story. A newly wedded couple named John and Jane, went to Las Vegas for their honeymoon. They had taken $10,000 with them, and it was to last them their week long trip, to the Grand Canyon, and the Hoover Dam, and other local sights.

They reached their hotel late after midnight, with the intention of crashing. But it was their first time in Vegas, and they were shocked and surprised to learn that their hotel had a casino! They found themselves pulled towards the machines, and before the hour ended they had blown almost all the money they had with them! All they had remaining was $10.

Jane was crestfallen. She said to John, “That’s the end of our holiday right there. All we can do now is catch the first flight back home tomorrow! Let’s go back to the hotel room and catch a couple of hours of sleep.”

The husband agreed, and together they walked up to their room. He was still clutching the last $10 bill in his hand.

Soon, Jane was fast asleep, but John couldn’t seem to settle down. He still wanted to have one last go at the tables. What if the odds turned in his favor? He had to have one last go, he just had to!

He tiptoed out of the room, without disturbing his wife, and went back to the tables in his pajamas. And, luckily for him, the odds did favor him now! Deal after deal went in his favor, and he doubled his money on every turn. An hour later, he was still playing. If he walked away from the tables then, he would have had just shy of a million dollars in his pocket!

Just then, the manager of the casino came up to him. He said, “Sir, we’re very sorry but you’ve reached the limit of our bet size. I’m sure you’d be interested in going to our bigger casino? We’ll be happy to take you there!”

And so they went. The manager brought out the hotel limo, and John got in. He’d never sat in a limo, but he did wish that he wasn’t in his pajamas. Still, here he was, riding on a million dollars and such good luck that he hadn’t had in his lifetime! He tipped the driver a $100 in casino money, and went into the next casino.

John really felt invincible. He was at the top of his form, and nothing could go wrong for him. And for a while, it did seem right! He grew the million dollars that he had brought in with him, and made it 3 million! He was taken up to the high security tables, where huge men in black shades were watching to make sure the players were safe. A couple of hours more, and he had nearly 10 million dollars to his name. Starting with just $10, that was a great achievement!

It was coming up to daybreak, and John couldn’t wait to go back to Jane and tell her the good news. With all this money, they could do all the things that they had always dreamed of doing: travelling the world, a big house, lots of pets and never having to work again! With all this going on in his head, he played one last hand. He bet all his money on it, but his luck didn’t hold. He lost all the money he had!

It turns out that when you don’t have any money, no casino sends out its limo for you. John had to walk back to his hotel, a long, solitary walk where the dreams that had been so close to reality were again banished to the distant horizon. It took him an hour to get back to his room, and as he entered Jane was just stirring.

“Where were you, John?”, she asked, rubbing the sleep out of her eyes.

“I went back to tables.”, he answered dully.

“Oh no! Did you lose more money?”

“No. Only ten dollars.”

“Oh. That’s all right then.”

— — — — — — — — — –

How much do you think did John lose at the tables? Do you agree with him saying that he lost only ten dollars? Or did he lose much more? Maybe ten million dollars?

If you think he lost only ten dollars, then you are falling prey to a well-known psychological bias called mental accounting, or the “House Money effect”:

We treat money that we win, discover or inherit much more frivolously than hard-earned cash. The economist Richard Thaler calls this the house-moneyeffect. It leads us to take bigger risks and, for this reason, many lottery winners end up worse off after they’ve cashed in their winnings. That old platitude — win some, lose some — is a feeble attempt to downplay real losses.

from “The Art of Thinking Clearly” by Rolf Dobelli.

Make a Financial Plan today!

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When I talk to people my age, in their twenties and thirties, about making a financial plan for them, I’m often given this answer:

“Oh, but I don’t know how my life is going to go. I don’t know who I am going to marry, or what career I will choose. Without answers to these questions, how can I commit to a financial plan?”

If I am entirely honest, this is exactly what I said too! The answer comes from the root of our insecurities. When we are scrabbling among those grimy roots, we fail to observe the larger picture, or even grasp that such a thing exists!

The truth is this: most people have similar lives in terms of milestones. Most people work, some take a break to study, most people get married, have a few kids, educate them while working the entire time, marry the kids off, and retire.

Right? That’s what is going to happen to most of us. True, maybe some get married earlier, others don’t get married at all. Maybe some retire early at 45, and others choose to work to the age of 70. These are minor aberrations in the grand scheme of things. If you were to make a financial plan today, you can make your best assumptions about your future goals today, and base your financial plan on that.

For example, you are a young married couple, and you make a financial plan assuming that you are going to have 1 kid, and buy a house in a decent neighbourhood. But as the years go by, you end up having two kids, and choose to buy a small car as well as your house. Well, that won’t be hard to manage, will it? If you’ve already planned for X, and you decide to go with 1.1 X, you can still make it happen.

Let’s consider another situation. Start with the same assumptions: 1 kid and a house. 5 years later, you’ve got 2 kids and paying the EMIs on the house, as you had planned. At this juncture, if you go out and buy a Jaguar on EMI without spending a moment to consider your finances, you’re staring at a quick road to bankruptcy!

But if you do take a moment and see what you can manage, it is quite possible that the answer will come to you. Maybe you give away one of your kids (nah, I’m just joking!) or dispose off a property which isn’t giving you as much rent as you had planned on, or looking at your lifestyle to see what changes can be effected in it to allow you to indulge in your fantasy.

So if you’ve planned for something, and what actually happens is slightly off from the plan, you can still adjust for it. Or if you change the constraints completely, you can still re-do your plan to make things happen as you want. It is all within the realm of possibility!

So there you go! Make a financial plan as early as you can in your working life. You won’t regret it!

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