Father of behavioural economics Richard Thaler got us talking about his nudge theory when he won the Nobel prize earlier this month.
Unlike normal economic theories that assume that all participants can take rational decisions, behavioural economics says as mere human beings, we are prone to irrational actions and therefore, need to be “nudged” in the right direction.
Thaler insists that ‘positive nudges’ regarding investments can work wonders. There are several examples of positive nudges by the government in our country. Tax concessions for some long-term savings products are probably the best examples.
Regulators, mutual funds and financial planners, among others, also try to nudge investors out of behavioural biases. To build wealth, investors need to heed the following nudges, though the desired outcome will lie in their ability to walk that final mile.
1. NUDGE TO SAVE MORE
While Indians are good savers, the rate of savings varies across age groups. “The main aim of the sub-35 age group is to improve their lifestyle, and hence the savings rate is low,” says Manoj Nagpal, CEO, Outlook Asia Capital. While there is nothing wrong in trying to improve one’s standard of living, the younger generation could be sacrificing its future prosperity in the process.
This is because there are several advantages to starting early. If someone starts saving at the age of 25, a modest investment of Rs 1 lakh per annum invested in an instrument that earns a CAGR of 12% is enough to generate a retirement corpus of Rs 5 crore at 60. However, if the investment is delayed by 10 years, the required amount goes up to Rs 3.5 lakh per annum. If the same is delayed by another 10 years, the required amount zooms to Rs 12 lakh per annum.
Early start spares future trauma
Investment needed to generate a corpus of Rs 5 crore at the age of 60 increases with delays
Investors will be much better off if they start early. Return assumed is 12% per annum
For the young, regular negative nudges that glorify consumerism can prove detrimental to building future wealth. The solution lies in maintaining a tight budget and controlling expenses. The way one looks at expenses and savings also needs to change. “Those who are saving less have to change the way they calculate their savings potential. Instead of treating income minus expenses as savings, they need to put savings first and spend only what remains,” says Nilesh Shah, MD, Kotak Mahindra MF.
A. Balasubrahmanian, CEO, Aditya Birla Sun Life AMC, concurs. “The probability of success is high once people start treating savings as an obligation like EMI,” he says. Then there is the impact of mental accounting. One tends to spend more when using a credit or debit card, than when using cash. Similarly, one also treats a windfall income like a bonus and regular income like a salary differently. “Bonus is treated as free money, so people usually splurge on consumer durables. Nudging is needed to save at least of part of it,” advises Nagpal.
It makes sense to treat a bonus as a deferred salary. “Once you realise that the bonus is also hard-earned money and not something that comes freely, the entire amount will not be blown away,” says Amol Joshi, Founder, PlanRupee Investment Services. That is not to say you should invest your entire bonus. While a part should be invested for long-term goals, the remaining can be used to meet short-term goals.
Manoj Nagpal, CEO, Outlook Asia Capital
“Bonus is treated as free money, so people splurge on durables. Nudging can save a part of it.”
So how does one invest one-time receipts? Experts suggest the systematic transfer plan (STP) route. “While SIPs work best for those who want to invest monthly, STP is for investors with sudden income. In STP, you get the benefit of fixed income investment and SIP,” says Kalpen Parekh, President, DSP Blackrock Mutual Fund. Setting achievable targets is another way to increase one’s savings potential. Just as crash diets don’t work, an over-ambitious savings target is likely to fall flat midway.
If the target is reasonable—it can be achieved without cutting out the fun from one’s life—the probability of success will be high. At the same time, the government can also do its bit to promote savings among the young. “To inculcate the habit of saving, the government needs to give additional tax benefits under Section 80C to those below the age of 35,” says Sumit Shukla, CEO, HDFC Pension Funds. The additional tax benefit will act as a nudge.
Also Read: How Nobel-winner’s idea of ‘nudging’ can be used to make the right personal finance choices
2. NUDGE TO INCREASE SAVINGS
Just saving is not enough. The quantum of savings and investment needs to increase on a regular basis, in proportion to increase in income. The increase happens automatically in the Employee Provident Fund (EPF), as contributions to it is fixed as percentage of salary. However, this automatic increase is restricted only to the hike in basic pay. For those using other investment avenues, the onus of increasing contribution lies with the investor.
By increasing the quantum of investments annually, one can reach a goal faster or generate a bigger corpus. For instance, let’s assume an investor who wants to buy a farmhouse worth Rs 80 lakh in 20 years is saving Rs 1 lakh per annum towards it. He invests the amount in an instrument that earns him a CAGR of 12%. If he increases the annual contribution by 5%, he will reach the goal in 18.5 years and at the end of 20 years, his corpus will be Rs 1.12 crore. He can reach the goal in 16.5 years if he increases his contribution by 10% annually. In that case, the final value after 20 years will be Rs 1.63 crore.
Step-ups help build bigger corpus
By increasing quantum of investment, one can also reach a goal faster
Annual increase in quantum of savings results in much bigger corpus. CAGR of 12% assumed
That will allow him to buy a bigger farmhouse or divert the extra corpus to some other goal. Ideally, the amount to be increased each year should be determined by the rate of inflation. “Inflation whittles down the value of your savings every year. You need to save more to maintain the original value,” says Joshi. For instance, the value of Rs 10,000 in September 2007 is Rs 4,685 now. Had you been investing Rs 10,000 a month then, you should be putting away Rs 21,346 now (see Inflation whittles down value chart).
Inflation whittles down value of money
More than double needs to be invested to match value of Rs 10,000 in 2007
Actual inflation during the last 10 years used for analysis
Since the value of rupee has been falling over the years, you need to increase your investments to match your savings with that of last year.
Though increasing investments in tandem with inflation is a sound strategy, it may not be possible for everyone to do so. “Step-up SIPs should be based on need and feasibility. It may not be possible for someone to increase an SIP by 10% when the annual increment is only 5%,” says Vidya Bala, Head, Mutual Fund Research, FundsIndia.
Most fund houses allow a top-up feature to increase your SIP amount at pre-defined intervals. “Investors need to use available tools like top-up SIPs. Water won’t come to you just because you are thirsty, you need to go to the well and fetch it,” says Shah. Those unwilling to do this themselves can take the help of online distributors and robo advisors.
3. NUDGE TO INVEST PROPERLY
Once one has decided to save more and increase the quantum regularly, the next step is to channelise the savings into suitable investments. “While Indians are reasonably good at saving, they are not good at investing”, says Shah. “Large amounts idling in savings accounts that generate 3.5% returns and in tax inefficient FDs tells us why we need to invest properly,” says Joshi. The following steps should act as a guide.
Amol Joshi Founder, Planrupee Investment
“Inflation whittles down the value of your savings. You need to save more to maintain the value.”
Overcome loss aversion
Loss aversion occurs when the pain of losing money is greater than the happiness felt in gaining an equal amount. If investors do not overcome this aversion, they may end up losing money. Take for instance those who leave their money idling in bank accounts, assuming it’s safe. “The risk of inflation is something everyone ignores and that is why most are happy with 3.5% returns, which is lower than inflation,” says Shah. For example, the value of Rs 1 lakh lying in a savings account since September 2007 would be Rs 1.48 lakh today, but it should have grown to Rs 2.43 lakh to match inflation. In other words, the value of Rs 1 lakh has come down to Rs 69,345.
Don’t let your money lose its worth
Value of money idling in savings accounts falls despite earning 4% return.
Despite the visible increase in money, investors lost because the return could not match inflation rate. The loss would have been higher if one considered the tax impact.
Actual inflation during the last 10 year used for analysis. Savings account interest rate assumed as 4%.
This loss would have been higher if one considered the tax impact as well. While it is necessary to take some risk, there is no need to take unnecessary risks. There are those who oscillate between avoiding all risks and taking unnecessary risks. “The risk profiles of some investors change with market conditions. Some investors who were totally risk averse a few years back, are ready to take higher risks now. Ideally, risk profile should change only based on the change in personal situations,” says Nagpal.
Keep it simple
In most cases, investors tend to divide their money between available options. For example, if one retirement plan offers an equity fund and another a debt fund, the tendency is to spilt the money between the two. Due to this tendency, people subscribe to all NFOs coming their way. This leads to over-diversification and a complicated portfolio. Sebi is trying to solve this problem on the mutual fund front by reducing the number of open-ended schemes. However, as this Sebi action has exempted closed-ended funds, the market may soon be flooded with NFOs of closed-ended schemes.
Moderate return expectations
A mistake most investors make is to assume high returns. “Most ignore the return moderation happening now. Debt market return has come down drastically in the past decade. Going forward, equity return will also moderate,” warns Shah. Looking at historical returns and not at potential future returns is another mistake. “The investor’s mind gets hooked to recent returns. When they seek products like natural resources and new energy funds, we alert them that they are thematic funds with cyclical businesses. Investors should either invest using SIPs or with long time horizons,” says Parekh.
Automate investment process
As people tend not to do anything when in doubt, money idles in savings accounts for months. The solution lies in starting long-term SIPs. Some fund houses offer perpetual SIPs. As the probability of stopping long-term SIPs is low, it will help investors generate wealth in the long-term. Rebalancing your portfolio is another important factor, and can be automated as well. Most people increase allocation when the market is doing well and reduce in a bear market. “Automating asset rebalancing takes out all biases and also helps you to do it more efficiently. This rebalance can be between asset classes or between categories,” says Bala. Regular rebalancing help book profit and at the same time, does not reduce wealth.
Compounding works more as years go by
An investment of Rs 1 lakh will grow to Rs 8.61 lakh in 19 years and to Rs 9.65 lakh in 20 years.
An investment of Rs 1 lakh growing at a CAGR of 12% assumed
Since power of compounding works best in later years, investors should not withdraw early
4. NUDGE NOT TO DIVERT FUNDS
Despite regular savings and investments, several investors fail to meet goals. This is because they keep using the money earmarked for goals for other needs.
Link investments to goals
Experts say segregation of investments for specific goals encourages the investor to save more and also prevents him from dipping into the corpus prematurely. “Once savings are earmarked for each goal, they assume that it is not available for anything else and therefore, the chance of diversion is less,” says Balasubrahmanian. Another way is to show them the mirror. “Once they realise that their long-term goals will not be achieved if they divert money for short-term goals, most people will not do it,” says Joshi.
Setting up an emergency fund is another way to keep investments safe. In case of a financial emergency, the investor can use the corpus to tide over the short-term crisis. However, investors should tap this fund only for real emergencies and not random needs. They should also make sure that it is invested in a liquid instrument and is readily available. However, the instant redemption facility is now restricted Rs 50,000 per day per folio by Sebi. If the emergency corpus is big, one can split this into more folios and also into different AMCs. Keeping an emergency fund in a fixed deposit with ‘sweep in facility’ is another option.
A. Balasubramanian CEO, Aditya Birla Sun Life AMC
“Once savings are marked for each goal, the chance of diversion is less.”
Use locked-in products
The best way to stop one from dipping into investments prematurely is by opting for investments that restrict liquidity. Long-term lockins help harness the power of compounding. “The power of compounding is back-ended and the maximum benefits come in later years,” says Joshi.
For example, assume that you have invested Rs 1 lakh and expect to get an annualised return of 12%. The corpus will grow to Rs 8.61 lakh in 19 years and to Rs 9.65 lakh in 20 years. In other words, Rs 1.03 lakh or around 11% of the corpus comes in the last year alone (see power of compounding chart). However, don’t ignore the problems associated with locked in products. To prevent investors from getting stuck with a non-performing product, the government should allow portability between investment products and tax accordingly.