The secret war on your savings has already begun!!

10 minute read

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Yawn. 

With all due respect to Mr Buffet, let’s be honest.

Do you seriously think that we really don’t get the fact that we have to save more and spend less.

The whole point is “most of us” get it. But to put it into action is where the difficulty lies.

Why??

The complex explanation..
Saving money is very hard, as we compare something that we can get right now to something abstract that we might be able get in the future. And for this we need to forgo the purchase and save the money instead.

The no nonsense explanation..
In a world of instant gratification, it is all about today..
The future is a problem for another day.
Desire first. Discipline later.
We want everything now. Period!

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And all this means one simple thing,
Saving money is going to be far more difficult in the future if it isn’t already!

Along with that, our dreams of that “someday when we have enough money and courage to go out and do things that really matter to us” also becomes a lot more distant.

If you haven’t realized it yet, the war against “our savings” and “our future dreams” has already begun and we have a group of very strong and intelligent enemies to fight against!

To ensure that we are well prepared for this war, let’s take the help of the famous war strategist Sun Tzu.

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So let’s decipher the first part of his advice..

Know Your Enemy:

Our enemies want us to save as little as possible and instead spend as much as possible. And unfortunately we have 4 of them

  1. Social Media 
  2. Digital Money
  3. Banks
  4. Marketers

So the first step is to know our 4 enemies well enough.

1. Social Media

It’s a normal mundane Wednesday evening. I open my Facebook feed. And these are few pics which pop out.

Immediate Reaction: “Whoa. When my friends are doing this, why not me ??”

Now this does two things- one it suddenly plants the temptation of a vacation in me (which wasn’t there earlier) and two it raises my aspirations to an international exotic location. But can I afford it ? Why worry. I have my credit card!!

A similar social pressure hits me every time I see some friend of mine showing off his new sedan, that Royal Enfield Himalayan, that new biker jacket, that awesome party,  that get together at the newly opened pub, that fancy meal at the new restaurant etc.

“Nearly 40% of American adults with social media accounts say that seeing other people’s purchases and vacations on social media have prompted them to look into similar purchases or vacations ” – American Institute of Certified Public Accountants.

So, more often than not we start comparing our lifestyle and spending habits to others via social media and end up spending money to  “keep up with our peers and our increased aspirations

The bad part is that the more number of people we start comparing ourselves to, the harder it becomes to keep up. This can lead to a feeling of financial inadequacy and a desire to spend money we might not have. The fact that many people are purposely projecting a more larger-than-life image on social media only adds to the woes.

Thus given the inherent aspirational nature of social media,  we encounter many budget-breaking temptations with increased time spent in social media and hence remains a strong enemy to “our savings”

Additional reading : 1) How social media sites make you spend more 2) Why social media makes us spend more money

2. Digital Money

Whenever you buy something, have you noticed that paying with cash feels a little different compared to paying with your credit card or debit card. Think about the last time a restaurant didn’t accept card payments and you had to pay in cash.

Did you notice that when you paid by cash instead of a credit or debit card it felt more painful though logically the amount still remains the same.

Welcome to the world of behavioral economics. This is a concept in behavioral economics known as the “pain of paying.”

Simply put, it says that

  • Whenever we part with our money it causes a feeling of agony or psychological “pain.”
  • This “pain” happens irrespective of how big or small the amount of money you are paying
  • This “pain” is higher if you pay in cash instead of credit card or an automatic payment 

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Strange.. Buy why?

  • It’s not exactly about using cash but rather about the transparency and tangibility of the payment
  • The more the transparent (read as visible) and tangible your payment is, the more is the “pain of payment”
  • The transparency of a payment in cash transactions where you can see the money moving out of one pocket and into a hand, increases the amount of pain of paying associated with a payment
  • On the other hand, the pain of paying is significantly reduced by electronic forms of payment (think digital wallet like Paytm, credit card, debit card etc) – which allow us to instantly receive pleasures of consumption while making payments even more invisible and intangible
  • Lower the transparency = Lower the pain = More money spent

“You’re not faced with actually spending that cash and to think about it. It kind of just disappears… It makes it easier to ignore what you’re paying, what your bank account looks like when you’re making that payment… You can avoid bad news easier.”
Queen’s University professor Nicole Robitaille

Key takeaway:

Though the amount is the same, it feels ‘less expensive’ and “less painful” to pay with the card or digital wallets  vis-a-vis cash

More money tends to be spent if you use an electronic payment vis-a-vis cash as the reduced pain of payment can lead us to spending more freely and not taking note of all our expenditures

If interested you can check out the video from the popular behavioral economist Dan Ariely to understand the concept in detail –

Current Scenario in India

  • No of mobile wallet users  > No of mobile banking users
  • No of mobile wallet users  > 3X no of credit card users
  • Total payments through digital instruments  – to increase 10X by 2020
  • Proportion of non-cash transactions is estimated to overtake cash by 2023
    Source: BCG-Google study

So going by the rate of adoption for digital wallets, in a few years from now, majority of our cash transactions would be replaced by digital wallets. The advent of domestic players such as Paytm, Mobikwik, global giants such as Apple Pay, Android pay and others will only add to the acceleration in adoption.

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The good news:
Digital payments simplify our lives by make spending hassle free, trackable and more flexible

The bad news:
However eliminating all the friction that comes with spending cash and swiping credit cards – i.e removing the “pain of paying” means that people will find it extremely easy to spend and as a corollary “saving for the future” becomes even more tougher.

“Saving money is already very hard. Do we really need to make the process of spending any easier?” – Dan Ariely and Merve Akbas

Thus digital payments is our second big enemy who will make us spend more (as spending becomes far more convenient and less painful) and thereby as a corollary “savings” that much more difficult!!

Additional Reading: Here’s proof you’ll be spending more money in 2016

3) Banks and other lenders

There is an additional element to the “pain of paying” concept.

The pain of paying is reduced when there is a period of time gap between when the purchase is made and when the money actually leaves your bank account.

This essentially means paying by your credit card or taking a loan via EMI (easy monthly installment) to purchase something, significantly reduces the guilt and pain associated with the spending and tempts us to spend more.

Also,

The pain of paying is further reduced as the payments are made in small installments

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The Indian context

Our consumer debt is significantly low compared to other countries..

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Further, since the loans that Banks have lent to corporate companies haven’t fared well in the last few years (Eg Mr Mallya’s Kingfisher Airlines) most of them have turned their focus on us (i.e retail credit).

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Simply put – THE BANKS ARE COMING FOR US!!
They want us to borrow more and spend more!!

Add to it the new breed of disruptive lenders who make it damn easy to borrow

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And a data rich future which will make it easier for many to take loans..


Source: www.exploringstartups.com & Link

Thus Banks and other lenders are our third enemy as they will tempt us to spend more and lure us into the EMI paying trap.

4.Marketers

One of the basic assumptions that I got wrong in my life till date was that
“I was in control of all my purchase decisions and was rational” 

But thankfully after being introduced to behavioral finance and psychology, I slowly started realizing that most of my buying decisions are secretly manipulated by marketers.

The Science of How Marketers (and Politicians) Manipulate Us

Marketers know how to encourage us to spend and how to work out natural impulses to increase our willingness to part with our cash.

The topic on the techniques that they use is an ocean in itself. So, instead of reinventing the wheel, let me share a few mind blowing articles which will give you a sense of how our purchase decisions are being manipulated by clever marketers.

As seen above marketers have been developing several techniques over decades and will continue to develop new, more targeted and more sophisticated strategies to separate us from our money.

Out of all the four enemies, I personally think marketers are the most deadly and will be extremely difficult to consistently keep off from their manipulations.

Conclusion:

Now an honest confession. While I have identified some of the most important enemies for our savings habit, at this juncture, however I do not have an exact solution on how to fight them.

So going back to Sun Tzu’s valuable advice:
Know your enemy and know yourself and you can fight a hundred battles without disaster”

Now while we have known our enemy, the next key step is to “Know Yourself” 

This means figuring out our various behavioral biases and decision making patterns which most often are exploited by our enemies to manipulate us.

I shall cover some important behavioral biases and their impact on our financial lives in the coming weeks. And most importantly on how we can attempt to give a strong fightback in this war against our savings.

If you like the content, it would be awesome if you could consider following the blog. 🙂

Till then happy investing as always!!

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Why the odds are against you when it comes to good financial advice

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)

Source: http://www.livemint.com/Money/AbOyobTzU0KrpbTSGEpysM/How-to-grab-70-of-a-premium.html

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.”

Source: http://www.livemint.com/Money/wkeodGRDFxDjPYP3TtSWGJ/Life-insurers-selling-policies-that-die-early.html

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 !!

Summary

  • 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