Even if you make one per cent more annually than the stock market returns, the long-term benefits are substantial
Dr Sheena Iyengar once conceptualised an experiment that became so famous it is often cited back to her. On one occasion, the head of Fidelity Research, “explained” the implications to her! She set up tables offering jam samples at a store in Menlo Park, California. Shoppers could sample jams and use discount coupons to buy the flavours they liked. When six flavours were offered, 30 per cent of shoppers who sampled, also bought. When a larger number of flavours (up to 24) were offered, only 3 per cent bought. Excess of choice caused confusion.
This has obvious implications for marketers. In theory, everybody wants as wide a choice as possible. In practice, the human brain cannot handle more than a limited number of roughly equivalent choices. Decision-making processes freeze on choice-overload. Choice-overload certainly occurs in the finance industry. There are potentially billions of mixes of funds, exchange traded funds (ETFs), pension schemes and so on. This follows directly from combinatorial maths, given thousands of listed companies and debt instruments. Combine these as funds do, and you have billions of products. In practice, faced with this overload, investors freeze.
The fast moving consumer goods(FMCG) industry has similar overload. Hundreds of soaps, lipsticks, toothpastes cater to the same income brackets. Marketers use branding and high-decibel advertising to create awareness for the products they tout. Ditto for telecom and civil aviation where dozens of schemes and discounts are always on offer. These industries are driven by consumer discretion, which is one of those buzz-words beloved of B-School graduates. Obviously, a lot of choice is better than no choice at all. Remember when Indian Airlines, MTNL, LIC and UTI were rammed down your throat?
Iyengar thinks there might be an optimal range of choice. But unfortunately no free market with multiple competitors will offer choices falling within that optimal range. It's up to the consumer to exercise discretion and find way to cut through choice-overload. This may be unimportant when choosing soaps and telecom service providers. It is critically important when constructing long-term financial plans.
Most of us don't bother to think about our financial choices. Some make it worse for themselves by being thoughtlessly active and choosing everything. In my experience, many types of sub-optimal investment patterns are caused by an inability to handle choice.
One pattern is followed by the “default” investor. He parks the tax-deductible limit in eligible instruments and dumps the surplus in fixed deposits. At the other end of the scale is the madly active equity investor, who buys every attractive stock and ends up with an unwieldy portfolio of hundreds of stocks.
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In high-inflation environments like India, the default investor's quality of retired life is at risk. He or she will see the value of savings eroded. Even an indexed government pension will not keep up with inflation between the Pay Commission hikes. Indian definitions of “low” inflation - 5 per cent wholesale price index (WPI) - are monstrously high. At 5 per cent, the value of money halves every 14 years.
The madly active investor does better than the default saver. But he usually ends up getting the same return he would if he invested in a broad index fund or an ETF basket. This is inevitable. As an equity portfolio expands in breadth, returns edge closer to the broad market. So the indiscriminate buyer could spare himself all the excitement and headache of managing a large portfolio without sacrificing returns.
Somewhere in between these extremes, savvy investors can find better ways to make choices.
But a clear perspective is required on the ultimate objective. Does the investor want to beat inflation? In that case, work out the asset allocation by class and go the index fund route with the equity portion of the exposure. Ignore active investment opportunities.
Does the investor want to beat the stock market return? In that case, higher equity exposures are required and active choices must be made in juggling assets like equity, debt funds, precious metals, other commodities and so on. Indiscriminately creating a huge portfolio will not beat the market. So, set an upper limit on the number of stocks held, and pick carefully.
By using consumer discretion to deliberately restrict your choices in an open environment, you make it easier on yourself. It is possible for somebody who is self-aware to pick the mix that works best. But you do need to make a conscious effort and the optimal mix is different for different folks. The effort is worth it. An extra 1 per cent return per annum translates into a big long-term gain.