The intelligent investor is a realist who sells to optimists and buys from pessimists

The intelligent investor is a realist who sells to optimists and buys from pessimists

 

Asset Allocation helps us to generate optimal risk-adjusted returns

 

By Gajendra Kothari

(The writer is Managing Director and CEO of Etica Wealth Management)

 

Let me begin my column with a valuable lesson in investing that I have learnt during the ensuing COVID-19 crisis. I have always been a buy-and-hold long-term investor for the last 10 years. No amount of volatility in the markets could shake my belief in the various equity mutual fund investments that I have made over the years. And I was preaching the same to other investors as well. The idea was very simple: create sustainable wealth by increasing SIPs over a long term of 20-30 years in simple diversified equity funds.

A viral problem

Everything was fine till the COVID-19 pandemic struck, and equity markets world-over came tumbling down. In March 2020, the markets were so volatile and most our team's time went in pacifying our investors' concerns. We had always done the right strategic asset allocation for our investors, considering their risk profile, time horizon and the goal for which they were making the specific investments. For example, an equity investment would only be advised for a minimum period of 5-7 years (preferably 10-plus years). Still, we realised that many investors who came in during the last few years couldn't digest the volatility even though their time frame was much longer.

 

We realised most investors would mean something else when they make a statement "I want to invest for 20 years in equity, and I am happy with 12 per cent average returns." What they meant was that they wanted almost 12 per cent returns every year, and in no year the portfolio value should be negative. I am not blaming them at all. That's classic behavioural finance at work.

Getting over the initial phase

Higher volatility makes an investor very nervous, more so in the early part of her investing days. The most difficult phase in investing is the first five years where 90 per cent investors would abandon their long-term financial plan at the first signs of major volatility. A right asset allocation framework could help investors make the journey much smoother, thereby ensuring she stays on track with her long term plan.

 

Lots of studies like the one mentioned above have been carried out time and again to prove that practising asset allocation would determine the bulk of the portfolio returns. Security/scheme selection or market timing has practically very little relevance. However, most of us (investors and advisors included) fall into the trap of security selection and market timing time and again.

Another lesson I learnt first-hand is asset classes returns (including sub-asset classes) always revert to mean levels over a period of time. I was doing my SIP in a small cap fund for 8 years and as at Jan'18 end the CAGR was 35 per cent per annum on the back of stellar small-cap rally of 2017. I didn't book profits because I believed in the classic buy-and-hold principle. And today, the 10-year CAGR has dropped to 14 per cent. Not bad, but it could have been much better had I practised asset allocation more prudently, i.e. the market is a pendulum that forever swings between unsustainable optimism (which makes asset classes too expensive) and unjustified pessimism (which makes them too cheap). The Intelligent Investor is a realist who sells to optimists and buys from pessimists. And if it can be practised across asset classes then over a long term, an intelligent investor can generate very healthy returns with much lower volatility.

Using the lessons

This time I could apply the lesson in another investment of mine in a China-focused mutual fund. My five-year SIP was showing a paltry return of 2.5 per cent at the start of 2019 and within a year, the six-year SIP returns had zoomed to almost 18 per cent annually. It means, the NAV of the China-focused mutual fund had risen by almost 40 per cent in a year's time. I took some profits off the table, while my SIP still continues. (It's another matter that I am proven wrong again since Chinese markets have gone up almost 30 per cent in the last 6 months). However, I am not regretting my decision as I made decent gains.

We have to remember that we can never get out at the top or invest at bottom levels. Asset Allocation doesn't strive to give the best returns. It just helps us to deliver optimal risk-adjusted returns. And if we can manage risk well, returns will be taken care of automatically.

 

As the legendary Warren Buffet says : Rule no 1: Don't lose money. Rule No 2: Don't Forget Rule No 1.

 

Happy Investing

Source: Moneycontrol.com