There are times when you make the mistake of seeing a financial decision in isolation and miss the big picture. At other times, you miss the details in pursuit of the big goal. Both are equally capable of harming and hindering the desired end result. We need to be aware of the common errors so that we can avoid them, or take steps to rectify them in case they have inadvertently crept into the way our money is managed.
Where big picture can get lost in the details
When you ignore the idea of opportunity cost and time value of money while making a financial decision to spend or save or borrow or invest, you are leaving an essential element out of the decision-making process. The decision to buy that much-coveted car is not only about negotiating the best price and a loan at the lowest interest cost. It is equally about the opportunity cost of how the money committed to paying the equated monthly instalments (EMIs) could instead have been employed to earn returns. An EMI of around Rs40,000 on a Rs20 lakh 5-year loan, if invested at 8% per annum, will grow to a corpus of Rs30 lakh. Consider what this corpus can do for your other goals before deciding on the new car. Similarly, think twice before you tell yourself that you have scored a good deal because you chose a zero-interest instalment offer instead of a discounted lump-sum current payout. If you did not take into consideration the impact of time value of money, your decision could be to your disadvantage. Paying less money immediately could prove to be a better option than paying a larger sum in instalments even if it is without interest.
When you postpone retirement savings, you are focusing on the immediate goals and ignoring the harm that forsaking compounding does to your long-term goals. Similarly, when you choose low-risk products, even when the investment horizon of your goals and your ability to take risk permits exposure to investments with higher returns albeit with greater risk, you are condemning your corpus to lower earnings and compounding benefits.
When you let money accumulate in the savings bank account and believe you have done your bit by saving, you are leaving things half done. Unless the money is invested, it is idle and not working for you and your future. If you have an adequate emergency fund and there are no imminent goals to be funded, there is no excuse for holding large sums of money in low-return products like savings bank accounts. When money is invested, earns returns and compounds and grows over time, it reduces the contribution that you have to make from your savings for the goals. This means, you could get to your goals faster and even expand your goals list.
Insurance is the other area where there are likely to be gaps between your actions and the intended consequences. For example, a collection of insurance policies accumulated over time to save on taxes, or to accommodate a friend who is an insurance agent, does not mean you are adequately insured. Similarly, when you believe that you have sufficient cover just because you pay out a large sum as premium, may be misleading. For the same amount of premium paid, the extent of cover provided will depend on the type of policy you hold. A term policy, which is a pure insurance product, will give you a bigger cover for the same premium, relative to the cover provided by a product that combines insurance with investment. Look at the cover provided, and not the number of policies held or the premium paid, to determine if you have the protection you need.
Where there is the risk of not sweating the detail
Overlooking the details in managing money has the potential to derail the entire process. For example, when you assume that investing is a one-time exercise and you are done once you have selected the appropriate product and made the investment. Your investments require periodic check-ups to ensure that they are doing as expected on the return and risk parameters. It is not enough if the investment is generating a positive return, it should generate at least the targeted minimum return or else you are likely to miss your goals. The returns should also be comparable to market returns as well as other similar investments. If your investments are consistently under-performing on these parameters, you need to switch your money to other investments. Not evaluating the performance of your investments periodically just because you don't have the time or skills to do it means leaving your funds to languish in poorly earning investments and under-utilizing your resources.
When you ignore the costs and fees associated with a financial product or service because you see it as too small an amount to sweat about, you may be limiting the growth of your corpus. If the costs and fees are deducted directly from the investment value, as in the case of mutual funds, they become even easier to ignore. Costs are a periodic drain on the investment value, and that portion of your corpus is no longer available to compound and grow for your needs. All the costs associated with an investment have to be accounted for to arrive at the real returns you earn from it. Use the real returns to compare investments with similar risks to ensure that you have the most efficient products in your portfolio. When you continue to pay premiums on an insurance policy that is not adding value to your financial situation and you have the option to surrender the policy, you are again wasting funds that could otherwise be used for better cover or towards your goals.
When you overlook the relatively small amounts you receive for interest and dividend payments on investments and do not reinvest these proceeds immediately, you are pulling down the actual returns you earn on an investment. The difference in expected return and the actual returns earned will translate into a shortfall in the funds available to fund your goals.
Most of us believe that we are quite capable of managing our money. And yet, we can relate to most of the situations described above. Setting in place a system and schedule for making and monitoring investments, and automating much of the process is one way of avoiding the slips. But you still need expertise for evaluating products and analysing performance.
A good way to take care of all these issues would be to stop dealing with your money as a DIY project and appoint a professional adviser to help you manage it. Qualification, experience, integrity and remuneration structure are important aspects to consider while bringing on board a professional to help. It may well bridge the gap between where you are and where you want to be.
In arrangement with HT Syndication | MINT
This article was originally published on November 17, 2017.
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