Best PAD : the new mantra for asset allocation

imgbd Your financial plan suggests an ideal asset allocation to achieve your client's goals, while his risk profile throws up an asset allocation that is way too conservative to enable achievement of his goals. What do you do now? Go by the risk profile and jettison the plan? Or hard sell your plan and get your client to change his risk profile? Advisors who understand that investing is more a mind game than a numbers game, are increasingly adopting Best PAD as the asset allocation solution in such situations.

MasterMind - a joint initiative between Sundaram Mutual and Wealth Forum, is aimed at providing advisors and distributors insights into the minds of investors, to enable you to relate to how your clients think, and thus become more effective advisors.

Through our Master Mind columns, we have looked at some of the behavioural traits that often lead investors to irrational and inefficient investment decisions (Inside an investor's mind). We have discussed concepts like loss aversion, averaging, sunk cost fallacy, availability heuristics, mental accounting, hot hand fallacy and a lot more. Most of the examples we have discussed in these columns deal with specific investment decisions and how you can help your clients make the right decisions by applying your insights from the world of behavioural finance.

A big behavioural challenge that advisors face actually happens much before a specific investment purchase / sale decision is made by the client. It happens when clients are influenced by exactly these very behavioural traits when you create a risk profile for them.

Consider this example

50 year old Mr. Rao saves regularly, is aware about the need to save for retirement, but invests only in bank deposits, and that too in a large Government owned bank. He has an aversion for the stock market, as he has seen his elder brother getting financially ruined in the 1990s in successive scams. His brother invested heavily in cement stocks at the height of the Harshad Mehta frenzy, lost huge amounts in the subsequent crash, and then a few years later, in an effort to make up for his losses, he invested in a big way in the infamous "Ketan Parekh" stocks, which effectively wiped out whatever was left.

You run the numbers for his retirement plan and come to the conclusion that his existing savings and future savings for the next 10 years until retirement will need to be ideally invested 40% into equity funds and 60% into debt funds, to give him the required retirement kitty from which he can draw down reasonably comfortably.

When he gives you his signed risk profiling sheet, you discover zero risk appetite for any market volatility of any kind. Your hands are now tied - you hesitate to recommend equity funds with such a zero risk tolerance risk profile. You run the numbers and discover that if he continues investing only in bank deposits, his retirement kitty will last him only 10 years of a retired life, and not 25 that you would ideally want him to plan for. What do you do now?

Option 1 : Path of least resistance

Recommend investments in low volatility accrual based income funds to make his returns more tax efficient than bank FDs, and give him a note in writing to state that this strategy is based on his risk profile and not on his retirement needs. State the risk of the client outliving his retirement savings due to a very cautious investment strategy, ask for an acknowledgement, file it, and proceed with the investment plan.

Option 2: Go by the plan, get the risk profile changed

Explain to the client the fatal flaw in an ultra cautious investment strategy, get him to understand that the real risk in the long term is not market volatility but outliving his savings, show him data and charts that show how time in the market defeats volatility and how equity is best positioned to beat inflation in the long term, help him understand that he has at least 10 years before he dips into this corpus - which is a great time horizon for equity investing and help him understand the difference between speculation (which his brother fell prey to) and equity investing through funds (which is what you are recommending). Once you have had a few sessions with him and you see him coming around to seeing merit in your argument, you ask him to complete another risk profiling questionnaire, this time with ticks on boxes that allow you to offer upto 40% in equity, and armed with the retirement plan and the new risk profile, you recommend what's right as per the plan: 40% equity and 60% debt.

Option 3: Best Practical Allocation Decision

Advisors are increasingly understanding and adopting the notion that is now popularly called Best PAD - the best practical allocation decision. Best PAD recognizes that both options 1 and 2 have practical flaws. Option 1 clearly is not making any effort to do what is right for the client, but is more focussed on protecting the advisor from a mis-selling claim. Option 2 seems right on paper, but experienced advisors know that when they "hard sell" their ideas to a reluctant client, even if the client agrees at that moment based on all your logical arguments, when market volatility eventually hits the portfolio, the client is very likely to get extremely jittery and abandon your plan. This does not help anybody in the long run.

For a plan to actually succeed over 10-20-30 years, advisors are increasingly adopting Best PAD as the strategy. Best practical allocation decision is an asset allocation that sits somewhere between options 1 and 2, and which allows the client to gradually work out his fears out of his system over time. There can be many versions of PADs, but one that many advisors adopt in our market is to agree a plan whereby the "capital" is invested into say accrual based income funds and returns are skimmed off and invested into equity funds. Over a 10 year period that he has before retirement, this skimming off can create an equity component that you would have ideally wanted on day 1.

Not the best outcome, but perhaps a practical one. You now get 10 years instead of 10 days to help your client gradually get over his equity fears and when you see this happen, you can always step up the equity allocation - this time with his wholehearted conviction rather than a doubtful nod that you would have extracted right at the beginning. The important point that Best PAD recognizes is that the right allocation is one that begins the journey in the direction the advisor is seeking to steer the portfolio, but at a pace that the client is comfortable with.

Who knows, if the client gets comfortable with equity through this gradual process, he may be willing to consider maintaining a 40% equity allocation even after retirement - which then takes away your fears of him outliving his savings. After all, that's your ultimate objective - it's just that you achieve it in a pace and manner that is practical, because you put time on your side to make course corrections in the original plan, rather than shooting for a perfect plan on day 1.

All content in MasterMind is created by Wealth Forum and should not be construed as an opinion of Sundaram Mutual Fund.

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