All of us are regularly making decisions of varying degree of importance, for most part of our lives. This may include serious ones like how to improve sales in your company, buying a new house, evaluating a new job etc to day to day ones like which route to take, which restaurant for dinner etc. While simple decisions don’t require much of an effort as the stakes are pretty low, however in situations where the stakes are high, the decisions that we take, need to be taken after some reasonable analysis.
Though the situations and problems will be different, if we can develop a set of thinking tools which we can apply selectively to various problems, it would help us to improve our decisions dramatically. In essence, you don’t want to start a bike repair shop with only one spanner, you essentially want to have various tools which you can use based on the nature of problem in the bike.
So with the same premise, we are going to slowly build our own mental tool kit which will help us both in our day to day lives and investing. Our first tool that we will be adding to our mental tool kit is called “Incentives”
Most of economics can be summarized in four words: “People respond to incentives.” The rest is commentary. – Steven E Landsburg
The basic idea is to ask the simple question “What’s in it for the fellow on the other side of the table”
Let’s apply this simple question to the financial industry and investing.
Most of us or someone in our family would definitely have an investment linked insurance product sold to us. But when it comes to mutual funds, most of us have hardly heard about them, leave alone buying them. Intuitively, our first line of reasoning goes – a better product gets more popular and hence insurance products must be better than mutual funds. But if you have held on to any investment linked insurance product (except for pure term insurance which in my honest opinion is the only decent product in the insurance industry) for more than 5 years and you do the calculation for returns, you realize the sad truth 😦
But what explains their popularity ??
You guessed it right. Incentives !!
When you are sold a mutual fund, the distributor commission is generally around 1% for equity mutual funds and around 0.5% for debt funds. So if you invest Rs 1 lakh in an equity mutual fund, your advisor will make just Rs 1,000 for the entire year.
But when you sell an investment linked insurance product, the first year commissions (including rewards) can be as high as 49% (see the below chart). So if your premium is Rs 1,00,000 then upto Rs 49,000 may go into the pockets of your agent or the bank. Then,the charges are capped at 7.5% of the premium till the 5th year and thereafter it is 5% of the premium. If you had a heart attack looking at this, hang on, these charges were even more exorbitant a few years back and the current rates are post the regulatory intervention putting a cap on the charges. You can imagine the “gala” times that your friendly insurance agent had those days.
You can see below the maximum commission charges for various plans and tenures. (Link)
This has led to significant mis-selling in investment based insurance products. Since the incentives are front loaded the focus is on churning your insurance products given the high 1 st year commissions. This behavior is evident as seen from the low persistence of holding an insurance product beyond 5 years. Refer to this article for a detailed explanation (Link)
Excerpts from the article,
“According to figures of financial year 2015, as reported by the insurance regulator in its handbook of statistics, the industry, on an average, reported a persistency of 59% in the 13th month, i.e., after a year of sale. In other words, out of 100, just 59 policies got renewed. In fact, the average persistency for the 61st month is about 22%, which means by the end of the fifth year, only 22 policies got renewed.
India compares badly with the rest of the world. The 13th month persistency in member countries of Organisation for Economic Co-operation and Development is above 90% and about 65% for the 61st month.”
This is a clear case of how incentives of our friendly insurance agent which are not aligned to our interests generally leads to a bad investing experience.
Quick take away:
At the current juncture, given the opaque cost structure, just-about-average investment managers who manage our money and not-in-our-favour commission structure avoid any insurance product which promises returns. Don’t confuse an insurance product with investments. If you need insurance, opt for pure term insurance which promise no investment returns but provide the insured value in case of your death within the term.
So, now let us assume you are just about 2-3 years into your career and you decide to save around 10,000 per month. Mutual funds are perhaps one of the best investment vehicle available for you (given their low costs, simple structure, high transparency, investor friendly regulator and the presence of seasoned fund managers). But you hardly have any knowledge on the markets and wish to work with an advisor. As you are relatively inexperienced, you also have a lot of queries and often get shit scared when markets go down. This means an advisor will also have to spend a lot of time hand holding you, meeting you, explaining to you about markets and stopping you from making hasty decisions. You would also like to meet your advisor regularly every month and discuss your various financial plans and queries. On top of it you are averse to paying your advisor. After all who pays for financial advice in India. We get it free of cost from our beloved news channels and friends 😦
So the advisor has to work on the wafer thin commissions that the mutual fund pays him which is approx 1% for distributing their funds. If your SIP is 100% equity, then the advisor gets around 1% of 1,20,000 (i.e 10,000 * 12) and it works out to Rs 1,200 !! Yup you read it right ..Lets assume the advisor remains patient and works with you for 5 years and your SIP of 10,000 each month has compounded at 15% and has increased to a value of Rs 9 lakhs. And how much does your advisor get paid for all this effort, honesty and persistence.. Rs 9000 !! Add to it the risk that the % of commission might further reduce after 5 years.
I hope you get the picture. Now you know why those lousy insurance products get sold to you (why in the world would anyone let go of an opportunity to make 30% plus 1st year commissions..to hell with long term client relationship). Did mutual funds not have a problem of incentives. Of course they did. The recent selling of closed ended funds (which had one time commissions which went as high as 7%) is a classic case. But the difference is you have an extremely investor friendly regulator by the name SEBI who regularly keeps a check on any possible investor unfriendly activities. While in insurance, the regulator IRDA continues to have its eyes closed on the high commission driven insurance sales.
For a good advisor, it generally makes sense to cater to larger clients where the efforts and time spent, while is the same as spent on a small client, provides him with a far better remuneration (a 1 cr client, with a 50% in equity and 50% in debt would provide an income of around Rs 75,000 per year)
So they key implication, is that if you are a small investor its extremely difficult to get decent and honest advice.
Now given this practical reality, the safest choice for all of us is to educate ourselves on the bare minimal basics of investing. Sounds boring. But think about this, in a career spanning 38 years from the age of 22 to 60, you end up working approx 79,000 hours in exchange for all the money you make. Don’t you think should spend just about 2 hours a month, which works out to just 1% of your overall work hours, on making your money work equally hard as you.
“Give me six hours to chop down a tree and I will spend the first four sharpening the axe.” – Abraham Lincoln
This blog is a small attempt from my part to ensure that all of us get good financial advice, and hopefully have a reasonably good investing experience. (intelligent folks should interpret these lines as shameless marketing 🙂 )
Now for those of us for whom investing sounds like greek and latin, and that’s the last thing on which you want to spend your well earned free time, don’t worry, all is not lost. To your rescue comes the new breed of online based advisors called robo advisors (Eg Scripbox, Arthayantra, Advicesure, Fundsindia etc) which are slowly gaining popularity. These guys provide advice through apps/websites with bare minimal human intervention and address the main issue of cost to service us, as most of the investment advice is standardized and can be easily scaled (think of uber, airbnb etc). While this is still at an initial stage and most of them are very basic, my sense is that in another 2-3 years we will have some really solid and evolved online advisory models for people like us. Till then let’s keep learning !!
- Keep an eye on incentives – Always ask what’s in it for the guy on the other side
- Investment-linked-Insurance products are injurious to your financial health
- Tough to find good financial advice for small investors – the incentives for advisors are tilted towards the larger investors
- Invest in improving your investing knowledge – no two ways about it !!
- Robo-Advisors, while currently at a nascent stage, may be the solution to decent financial advice for small investors in the coming years