The Hindu Business Line : Savings are not equal to investments: Need for financial literacy

Investment World - Investments
Markets - Financial Services
Columns - Micromotives
Savings are not equal to investments: Need for financial literacy

B. Venkatesh

The difference is striking. High net worth individuals take adequate steps to route their savings to optimal returns-bearing assets.

The mass affluent — those aspiring to become high net worth individuals — care more about reducing current taxes. Informal discussions in the marketplace show that the contrasting behaviour is primarily due to the difference in financial literacy between the two groups.

This article provides some reasons for the difference in financial literacy levels. It also shows how these differences act as impediments to the aspirations of the mass affluent, sometimes leading to increase in their portfolio risk.

Investment attitude

The Organization for Economic Co-operation and Development (OECD) defines financial literacy as, “The process by which financial consumers/investors improve their understanding of financial products and concepts … develop the skills and confidence to become more aware of financial risks and opportunities to make informed choices… .”

This definition shows that a need for financial literacy arises if individuals are aware of the importance of making informed choices. And that appears to be the problem.

A typical mass affluent investor is motivated to save, but makes no effort to differentiate between savings and investments.

In an economic sense, savings is the excess of income over expenditure. And investment is the process of routing savings into optimal returns-bearing assets.

The problem is that the mass affluent primarily make investments in March each year to save taxes. The lack of effort to search for optimal investments through informed choices stems from a common complaint — lack of time.

More precisely, the argument is that “the time spent on becoming aware of the investment process can be better spent in the office, generating more income”.

This argument reveals the lack of understanding of the concept of passive income — income earned without being actively involved in its generation.

Investments earn passive income. It, therefore, pays to take time to empower oneself with the knowledge to make discerning investments.

Portfolio tilts

The disinterested attitude towards financial literacy leads to several problems. One, the portfolio is not constructed to achieve a certain investment objective. Research in the US has shown that the vast difference in wealth among households with similar age and income groups is due to the difference in planning. Failing to channel savings into optimal avenues is a failure to plan. And this could lead to lower-than-desired post-retirement lifestyle.

Two, investing to primarily reduce taxes results in a portfolio which is built one asset at a time. This often leads to concentration of holdings. The reason is that each asset is bought without considering its correlation with other assets in the portfolio.

And three, several mass affluent who do invest, engage in naïve portfolio diversification. If they are introduced to four different products (two of which may be similar and the other, not very different), they often choose to divide their assets equally among all the products. Behavioural economists call this process 1/n heuristics. This could again lead to concentration risk if two or more products carry the same investment style.

Conclusion

The lack of informed choices through mid-career could lead to needless risk-taking behaviour towards retirement. This stems from typical tiered behaviour among individuals — hopes for riches and protection from poverty, which is the reason why an individual buys insurance as well lottery tickets.

Behavioural economists have shown that individuals accept lottery-like odds when they are below their aspiration levels and reject such odds when they are above their aspiration levels.

What happens when an individual realises that her “savings” is not enough to help her lead a desired post-retirement lifestyle? She may be forced to make high-risk investments, perhaps, at a time when she needs more exposure to bond-like investments. This problem can be moderated if optimal investments are made through the working life — a process that can be facilitated through financial literacy.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at enhancek@gmail.com)

More Stories on : Investments | Financial Services | Micromotives

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page