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Understand and control

How understanding empowers you to control your financial future

Understand and controlAnand Kumar

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Warren Buffett, the legendary investor, once said that if calculus or algebra were required to be a great investor, I'd have to go back to delivering newspapers. To be a successful investor, one didn't need any more maths than plain old addition, subtraction, multiplication, and division. However, don't tell that to the professional peddlers of complexity who seem to infest the world of investing.

Some years back, a young' relationship manager' of some bank approached me and asked for the formula for asset allocation. He planned to input his clients' numbers-as he called them-into an equation that would magically determine the optimal distribution of their funds across various asset classes. I had to break the news to him that there was no such formula. I explained to him that deciding on an ideal asset allocation relies more on a set of rules of thumb, which are then tailored to an individual's unique life circumstances. The process involves considering numerous qualitative and non-quantifiable factors that cannot be reduced to maths.

To my surprise, the young professional was visibly disappointed by my response. He had hoped for an impressive formula adorned with a sufficient number of Greek letters like alphas, gammas, sigmas, pi's, and taus. The more calculus involved, the better, as it would undoubtedly impress his clients. He made it clear that he felt let down, either because I was unaware of such a formula or unwilling to share it with him. The idea that there was no set formula was simply unacceptable to him.

While this young man was in the profession of selling fake complexity, many investors themselves are unable to accept that investment can be simple. I think the difference is between trying to look at the questions and their answers and trying to understand the logic behind the answers. Take the concept of asset allocation itself. You can accept it as a given instruction, or you can understand the why. The concept of asset allocation is rooted in the idea of diversification-not putting all your eggs in one basket. By spreading your investments across different asset classes like equity, fixed income, and a few others, you're essentially hedging your bets. When one type of investment takes a hit, the others might hold steady or even flourish, helping to balance out your overall portfolio.

Once you know the logic, you can take the next step yourself. You already know that equity earns more but has more ups and downs. Fixed income is the other way around. Combined with the knowledge about why we must do asset allocation, what does this tell you about what your actual asset allocation should be at different stages of life? However, my topic is not asset allocation; that's just an example. It's about the importance of understanding the underlying logic behind investment strategies and concepts. When you grasp the fundamental principles, you gain the confidence to make informed decisions and adapt your approach as needed. No one can force you into believing imaginary formulae.

Too often, investors get caught up in the allure of complex formulas and fancy jargon, thinking that these hold the key to investment success. They may feel intimidated by their lack of advanced mathematical skills or swayed by the impressive-sounding rhetoric of financial professionals. However, even legendary investors like Warren Buffett emphasise the importance of simplicity and common sense over complex calculations. By focusing on understanding the basic building blocks of investing, such as the relationship between risk and return, the power of diversification, and the impact of time horizon, investors can develop a solid foundation for making sound decisions. They can see through the fog of complexity and hone in on the factors that truly matter for long-term success.

This understanding breeds confidence. When you know the why behind the what, you're less likely to be swayed by short-term market noise or the latest investment fads. You can stick to your strategy with conviction, even in the face of market turbulence or conflicting advice.

Also read: Diversification: How to get it right?

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