How a family can plan its finances holistically

The necessity of having a good plan to manage family money cannot be overstated. Having a holistic plan is necessary but not sufficient condition to preserve and grow wealth and achieve family goals. At best, it should act as a guard rail and guiding post for the next turn and not the entire journey.

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A holistic plan is one which is prepared for most possible outcomes (internal and external) and considers both behavioural and analytical aspects of decision making.

Nassim Taleb puts it brilliantly: “If you want to figure out how a thing works, first figure out how it breaks.” If we study the reason for wealth destruction in families, mostly it is internal rather than external. Greed, hubris, imprudence create more harm to family wealth than war, inflation or recession.

Need for clarity

Primium non nocere – First, do no harm. The first step towards a holistic financial plan is having clarity on what is really needed for the family. Both the family and planner have to work hard to get their thinking clean and make it simple. A few goals such as children’s education and marriage, and retirement are common to every one’s life and should be part of the plan.

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Other goals such as vacation, second home, starting a new business, early retirement etc are very personal and need to be really thought through. In essence, beyond some technicality, financial planning converges with life planning and becomes a sub-set of it. Amazon founder Jeff Bezos said: “Focus on what will not change in 10 years rather than thinking what will change.” This is a great piece of advice for anyone who is taking the first step to create a plan.

Risk and volatility

Another important aspect of holistic planning is the concept of uncertainty, risk and volatility. It applies greatly to financial planning. Investing in markets is dealing with a complex system where everything affects everything else and the systems are in perpetual motion. Also, global markets are linked with each other due to financial integration. All this make investing challenging.

Hence it is important for the family to know the following things. Volatility is an expression of risk and not risk by itself. Risk is something you can put a price on. Odds are known and one can budget for it. Uncertainty is hard to measure and cannot be budgeted or accounted for.

The important thing to note is that risk can be budgeted but uncertainty can only be embraced or hedged. To start with, a family should assess how much risk capacity the plan allows for and how much risk tolerance it has.

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For instance, if one of the goals is to buy a car in the next six months, the risk capacity permitted by the plan is the least. Also if the family is really uncomfortable seeing 5 per cent erosion of capital on a temporary basis, the risk tolerance is very less. There are a lot of tools available to help families/planners with psychometric testing to determine risk profile.

Investment framework

Once the financial objectives are defined and risk assessment is done for the family, the next step is to create an investment framework. In essence, an investment framework should help realign long-term capital to long-term assets, after budgeting for short-term liquidity requirements and contingencies. This is an important decision making node for the family/financial planner where they have to decide on asset class participation, allocation and its location.

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Asset class Participation: Often it is asked as to why one should have diversification across asset classes. Quoting Warren Buffet, “Diversification is a price we pay for our ignorance.” Uncertainty cannot be budgeted for; it can only be hedged or embraced. Hence diversification across various asset classes helps a family to hedge future uncertainty and prepare the portfolio for various economic outcomes.

The important pillars of asset class participation are real estate, equity, gold and debt (not in any order). There are other asset classes such as private equity, art and passion investments. These asset classes should be evaluated if one has expertise of subject matter and time on hand. Also, most of these other investments have liquidity constraints and hence one should think very prudently before making them a core part of the investment allocation. An important objective of any plan is not to be asset rich and cash poor.

Asset Allocation: Deciding on the percentage of capital to be allocated to an asset class is a function of risk assessment done for the family. Analytically it is a very simple exercise but is the most difficult concept to execute in practice. Studies suggest if one does attribution analysis for investment gain from a diversified portfolio, 91 per cent of the gain can be attributed to asset allocation. Right execution of asset allocation is one of the cornerstones of any financial plan and its success.

One of the observations is that if any asset class does not give par return for 3 to 5 years, ownership in the portfolio goes down significantly or becomes zero. The recent example is having gold in a portfolio as a protection asset. Since gold didn’t perform well from 2011 to 2017, it had a negligible presence in most of the portfolios. A practical hack to this problem is to stay away from narrative and stories. The human mind is more susceptible to stories than facts. Most of the narratives and stories are post facto and after price performance.

Asset Location: Deciding on ownership of assets and how it is located is also very important. We believe one should be open minded and do the full spectrum of analysis on available opportunities. In each asset class there are multiple choices available to align investments with financial objectives. If the portfolio is in need of regular income, maybe bonds are a better option but if liquidity is required debt mutual funds will serve the purpose.

If one wants to build long-term annuity, options such as REIT and InvIT should be explored. Direct equity ownership can be explored if one is building a long-term intergenerational portfolio and has active involvement. The point to ponder is what choice will help you opt for simplicity over sophistication and still achieve your objective.

Maintenance matters

It is a fact that disproportionate energy goes in building something rather than maintaining it. Maintenance is underrated and building is overrated; hence, the key to success is maintenance. After the creation of a financial plan and investment framework, regular diligence (at least quarterly) with your advisor and rebalancing prudently is perpetual work-in-progress. It is very difficult to re-balance the portfolio in panic and mania. About 90 per cent of investors failed to re-balance portfolios in favour of equities in March 2020; reason: Fear.

Today it is equally difficult to re-balance to reduce allocation to Nasdaq if it has become overweight; reason: Greed. These are a few examples of how behavioural aspects impact portfolio outcome more strongly than external events. In times of crisis or euphoria only framework works; willpower gives up.

As in other aspects of life, the key to success lies in execution. There are some time-tested principles and learnings which can help execute plans better:

• Have a long time preference – The only sustainable and real big edge that families have against big institutions is long-term investment horizon.
• Distinguish between desirable and attainable. Most investment success also depends on initial conditions and hence this distinction will help family set realistic goals.
• Do not underestimate liquidity. Having assets which provide liquidity during tough periods is a game changer.
• Wu Wei is a philosophy of passive achievement. Often, in investing, a bias for inaction — rather than constant churning — helps.
• Often decision making will happen between ignorance and knowledge, hence thinking probabilistically will be of immense value.

Holistic financial planning in essence is about finding your own equilibrium. This will protect the family from internal and external headwinds and help creating wealth in good times.

Lastly, festina lente — make haste slowly

The author is CEO and MD of TrustPlutus Wealth Managers (India)