Do the rich know something?
IN A recent survey of Global High Networth Individuals, Cap Gemini/ Merrill Lynch found the following allocations to asset classes:
Equity: 31 per cent,
Debt: 23 per cent,
Real Estates: 20 per cent,
Cash/Deposits: 13 per cent and
Alternate Investments: 13 per cent.
The average urban Indian's allocation in comparison looks something like
Equity: 3 per cent,
Debt: 12 per cent,
Real Estates and Gold: 21 per cent and
Cash/Deposits: 64 per cent
(NCAER Max New York Life Survey 2007).
On a weighted average basis with historic asset class returns, that's a difference of 4 per cent net return per year, that is, a difference of 3.2X over 30 years!
You bet the rich know something!
It's all in the asset allocation
This is even more striking considering the rich need to be conservative with their larger corpus and yet, they choose a better allocation. How can they be so cavalier? They are not; with higher net worth the aversion for risk actually increases. So, it is clearly not that they are more risk taking. Empirically, asset allocation in the portfolio is the single greatest driver of return. But the above portfolio is higher risk than the average Indian holding, right? Not necessarily!
Individually, each asset class has a risk-return profile but in a portfolio, the total risk is much lower than the sum of individual risk. This is the idea of diversification, where your portfolio return is an average across asset classes, where losses from one are absorbed by another. Further, a 100 per cent allocation to risk free securities (Gilts) is not optimal on a risk adjusted return basis. This is the basis of the modern portfolio theory called the efficient frontier. How do the rich know this? They have access to the best advice and robust analysis. But, now you can peak into their playbook and know exactly why they do it!
Is there a cultural bias to these allocations? Interestingly, not amongst the rich around the world, but strong differences exist by culture on an aggregate basis. This can only be explained as better access to information and learning. India has the highest savings rate of 28 per cent in the world; it also has the highest household gross contribution to the gross domestic product (GDP). So, putting these together and a 4 per cent increase can add 2 per cent to the GDP growth rate—Wow!! Can this happen? Yes!
The US and UK have become world's largest economies partly because they earn more on their savings than continental European economies. The Indian policy makers realise this and are, therefore, doing their most to encourage a higher allocation of domestic savings to equity by introducing some of the most favored tax treatment for equities in the world.
Number crunching
Let's do a quick retirement plan assessment. Suppose your annual family income is Rs 10 lakh. You pay 30 per cent in taxes and save 30 per cent or Rs 2 lakh per annum. Your monthly expenses add up to Rs 41,665. So, our first goal is to find out how much this expense will be 25 years on, when you retire. Inflation will reduce your buying power for each rupee and your standard of living will go up over this time, trading up from a Maruti to a Corolla perhaps!
Let's assume this is 5 per cent, a conservative estimate. But wait, you can reduce your expenses in retirement as a lot of your responsibilities would be taken care of by then. Let's assume that you can live on 90 per cent of your pre-retirement monthly expense. One little thing, you still have to pay taxes! Let's say, that rate is lower in retirement at 20 per cent. Putting these numbers together you would need Rs 2.4 crore saved up at retirement!
Now, let's see if that is feasible with the 8 per cent historic return from deposit products. Assuming you have a corpus of Rs 1 lakh saved and you would be adding Rs 2 lakh a year in savings, further that the savings will increase by 3-4 per cent for the duration of your work life. These are very generous conditions. The amount you will end up with at retirement is Rs 1.4 crore, an entire crore short of what you need!
Now, the very realistic scenario above is just planning for your life in retirement, it has made no extra provision for your kids' education, those overseas vacations or any of the things that you want in addition to your normal expenses. Any large (typically six months of savings or more) or unplanned expense will make you horribly insecure about your financial future. This is because the entire analysis above is contingent on compounding, which will amplify the projected short fall. But you have silver bullet—real estate!
True, real estate has outperformed in the past decade and so has emerged as a bulburk of the middle class retirement. Real estate is great only if you see it exclusively as an investment asset class. In India, these are highly emotional purchases, that are illiquid, require maintenance and tax payments. These are great insurance plays but are poor sources of income. The point in all of this is that you simply cannot afford to ignore equity as an asset class if you seriously want to plan your financial future. I know a lot of you wanting to know if using equity in the above example bridges that short fall. Yes, even after factoring in a lower progressive allocation to equity over time to account for risk!
Sum up
If you are not the number's kind and glossed over the frightening figures above, here are some changes that our generation will face much more than the generations past.
• Increasingly, people are taking more ownership of their investing lives. This is being accompanied by the phasing out of defined benefit pensions, long the cornerstone of retirements. The message is clear: the individual bears all risks.
• Job security is fast disappearing leading people to worry about their financial future.
• Inter-generational savings is becoming a thing of the past, so people are looking to formal investment options to structure their future.
• India is transitioning from a supply constraint to consumer led economy. Increasing affluence is raising the need for employing savings to more productive uses. There is high empirical correlation between investment growth and material disposable income.
• Given a large (63 per cent) percent of India's domestic savings are in low yield savings products especially gold, the government is working hard to bring this capital to more productive uses by an encouraging tax regime on equity ownership.
IN A recent survey of Global High Networth Individuals, Cap Gemini/ Merrill Lynch found the following allocations to asset classes:
Equity: 31 per cent,
Debt: 23 per cent,
Real Estates: 20 per cent,
Cash/Deposits: 13 per cent and
Alternate Investments: 13 per cent.
The average urban Indian's allocation in comparison looks something like
Equity: 3 per cent,
Debt: 12 per cent,
Real Estates and Gold: 21 per cent and
Cash/Deposits: 64 per cent
(NCAER Max New York Life Survey 2007).
On a weighted average basis with historic asset class returns, that's a difference of 4 per cent net return per year, that is, a difference of 3.2X over 30 years!
You bet the rich know something!
It's all in the asset allocation
This is even more striking considering the rich need to be conservative with their larger corpus and yet, they choose a better allocation. How can they be so cavalier? They are not; with higher net worth the aversion for risk actually increases. So, it is clearly not that they are more risk taking. Empirically, asset allocation in the portfolio is the single greatest driver of return. But the above portfolio is higher risk than the average Indian holding, right? Not necessarily!
Individually, each asset class has a risk-return profile but in a portfolio, the total risk is much lower than the sum of individual risk. This is the idea of diversification, where your portfolio return is an average across asset classes, where losses from one are absorbed by another. Further, a 100 per cent allocation to risk free securities (Gilts) is not optimal on a risk adjusted return basis. This is the basis of the modern portfolio theory called the efficient frontier. How do the rich know this? They have access to the best advice and robust analysis. But, now you can peak into their playbook and know exactly why they do it!
Is there a cultural bias to these allocations? Interestingly, not amongst the rich around the world, but strong differences exist by culture on an aggregate basis. This can only be explained as better access to information and learning. India has the highest savings rate of 28 per cent in the world; it also has the highest household gross contribution to the gross domestic product (GDP). So, putting these together and a 4 per cent increase can add 2 per cent to the GDP growth rate—Wow!! Can this happen? Yes!
The US and UK have become world's largest economies partly because they earn more on their savings than continental European economies. The Indian policy makers realise this and are, therefore, doing their most to encourage a higher allocation of domestic savings to equity by introducing some of the most favored tax treatment for equities in the world.
Number crunching
Let's do a quick retirement plan assessment. Suppose your annual family income is Rs 10 lakh. You pay 30 per cent in taxes and save 30 per cent or Rs 2 lakh per annum. Your monthly expenses add up to Rs 41,665. So, our first goal is to find out how much this expense will be 25 years on, when you retire. Inflation will reduce your buying power for each rupee and your standard of living will go up over this time, trading up from a Maruti to a Corolla perhaps!
Let's assume this is 5 per cent, a conservative estimate. But wait, you can reduce your expenses in retirement as a lot of your responsibilities would be taken care of by then. Let's assume that you can live on 90 per cent of your pre-retirement monthly expense. One little thing, you still have to pay taxes! Let's say, that rate is lower in retirement at 20 per cent. Putting these numbers together you would need Rs 2.4 crore saved up at retirement!
Now, let's see if that is feasible with the 8 per cent historic return from deposit products. Assuming you have a corpus of Rs 1 lakh saved and you would be adding Rs 2 lakh a year in savings, further that the savings will increase by 3-4 per cent for the duration of your work life. These are very generous conditions. The amount you will end up with at retirement is Rs 1.4 crore, an entire crore short of what you need!
Now, the very realistic scenario above is just planning for your life in retirement, it has made no extra provision for your kids' education, those overseas vacations or any of the things that you want in addition to your normal expenses. Any large (typically six months of savings or more) or unplanned expense will make you horribly insecure about your financial future. This is because the entire analysis above is contingent on compounding, which will amplify the projected short fall. But you have silver bullet—real estate!
True, real estate has outperformed in the past decade and so has emerged as a bulburk of the middle class retirement. Real estate is great only if you see it exclusively as an investment asset class. In India, these are highly emotional purchases, that are illiquid, require maintenance and tax payments. These are great insurance plays but are poor sources of income. The point in all of this is that you simply cannot afford to ignore equity as an asset class if you seriously want to plan your financial future. I know a lot of you wanting to know if using equity in the above example bridges that short fall. Yes, even after factoring in a lower progressive allocation to equity over time to account for risk!
Sum up
If you are not the number's kind and glossed over the frightening figures above, here are some changes that our generation will face much more than the generations past.
• Increasingly, people are taking more ownership of their investing lives. This is being accompanied by the phasing out of defined benefit pensions, long the cornerstone of retirements. The message is clear: the individual bears all risks.
• Job security is fast disappearing leading people to worry about their financial future.
• Inter-generational savings is becoming a thing of the past, so people are looking to formal investment options to structure their future.
• India is transitioning from a supply constraint to consumer led economy. Increasing affluence is raising the need for employing savings to more productive uses. There is high empirical correlation between investment growth and material disposable income.
• Given a large (63 per cent) percent of India's domestic savings are in low yield savings products especially gold, the government is working hard to bring this capital to more productive uses by an encouraging tax regime on equity ownership.
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