After going through the Financial Planning of a large number of people which have been done by various Financial Planners and also having read and watched programmes on the same in Business Papers as well as the Electronic Media I have come across some apparent pitfalls that should be taken into account by investors. The important thing is to have a Financial Plan that is dynamic and responds to changing macro economic conditions as well as the quality of life improvement with comes with growing income levels. There are a lot of things which cannot be captured in a pure income /inflation projection model. Some of the factors that I think are the most relevant are the follows-
Extrapolation of Historic returns – Most Financial Planning models are based on either extrapolating of historic returns or extrapolation of current conditions. However changing economic cycles as well as growth cycles can change the actual returns significantly. For example financial planning being done in the year 2003, where equities over the previous 10 years had actually delivered no returns would have led to an asset allocation low in equities. This would have led to a significant misallocation of assets in terms of future returns as the next five years delivered an average of over 40% returns per annum. Similarly an allocation done in the year 2007 could have led to an over allocation towards equities. However, then the question arises that what is the right way? The right way in my view is as follows. The long term return expectations from equities will be a function of Nominal GDP growth, improving productivity in the economy & building global competitiveness. Now Nominal GDP growth in India should average 12-15% & productivity improvements 2-3% over the long run. Global competitiveness is difficult to measure but once built sustains over long periods of time as has been apparent in the case of the Indian IT & Pharmaceutical industries. As such long term equity returns will average 15-20%. However returns from equities tend to be volatile. In the year 2008 markets were down 51% & were up 72% in 2003. As such cycles of asset returns necessitate reallocation.
This article was published in the MINT Newspaper on the 30th of October. To read the rest of the article the link to the same is given below
http://www.livemint.com/Money/fgJygxbSjTwVOoHTV2KGuN/Move-from-a-textbook-financial-plan-to-a-practical-one.html