Friday, May 27 2022

Empirical evidence suggests that investors can be their own worst enemies when they change their investment plans in the face of adverse market conditions. At the bottom is depression, followed by hope, optimism and euphoria respectively. Interestingly, at the bottom, i.e. depression stage, the actual risk to the portfolio is minimal as the downside is limited. On the contrary, during the market excitement and euphoria cycle, the risk in the portfolio is at its maximum. But investor psychology and the markets are often inversely correlated. During the cycle of depression, there is a maximum of fear and in the stage of euphoria, there is a maximum of greed. Market swings emotionally challenge investors to sell their champions in difficult times brought on by black swan events like the first covid outbreak and now the ongoing geopolitical crisis.

It is in these situations that a strategic asset allocation plan brings long-term stability to a portfolio by minimizing constant adjustments, driven by emotional decision-making, in a portfolio. In the United States, Vanguard conducted a study on the returns of a portfolio composed of 60% stocks and 40% bonds. From 1926 to 2020, a 94-year history, an investor would have achieved returns of 9.1% per year In India, a similar combination of large cap stocks and bond index would have resulted in a return of 10.5% per year from 1995 to 2022. These are certainly good returns for maintaining your risk-based asset allocation over the long term.

Another common mistake that high net worth individual investors (HNIs) make is to increase cash by substantial amounts during volatile stock market movements and reduce equity exposure due to perceived higher risk. Cash can be a double edged sword and we have seen many good fund managers underperform due to a high cash allocation. In fact, as stock market valuations become attractive during a depression cycle, investors should make a tactical decision (short to medium term) to overweight equities by 5-10%.

Diversification is another risk neutralization tool that can help reduce volatility. However, one must be careful not to diversify too much within an asset class, thus sparing oneself lower returns. Once again, the diversification of stock portfolios increases during the upswing of the markets where the psychology of investors pushes them to invest in new ideas that promise to give better returns than the champions they currently hold. While we don’t suggest sleeping behind the wheel, it’s crucial to assess and sell the laggards (not the champions) and the long tail of the portfolio before adding more likely winners.

Winners or champion stocks would be companies that are established leaders in their business segments with growing market share, have demonstrated consistent growth in the past, and are expected to grow at least 12-15% annually over the of the next 3 years. One should not be tempted to sell such champions as they display the maximum payout in the market, and that would be tantamount to selling family money. On the other hand, the laggards would be the companies that were bought from a tactical perspective and whose investment thesis did not play out or whose companies were unable to retain market share. These companies could also be those with more volatile prices and those that generally require higher capital. In our experience, there is typically 10-20% (by value) of stocks in a portfolio that could be exited. Sector and stock rebalancing should be done at this point rather than diversifying further.

From the stage of euphoria, which we saw in 2020-21, to the stage of anxiety and fear, in the first quarter of 2022, it is abundantly clear that these are unstable times. These risks have been heightened by geopolitical tensions and rising global inflation which threatens to dampen global growth.

However, even if global growth slows from the expected 4.2% to around 3% in 2022, it is still a very good growth story. Growth in India would also slow down, although to a lesser extent because the economy is isolated. War situations can disrupt global trade and currencies, but trade and growth are like water; Eventually, they will find their own way. Staying optimistic in a pessimistic economic scenario is the key to ensuring steady returns. If you own your champions, stick to the asset allocation plan, and don’t act in volatile situations, you should be able to come out of this unscathed and unscathed. Trusting your advisor, monitoring your portfolio and, most importantly, sticking to your investment plan will help you navigate choppy waters.

Nimish Shah, Chief Investment Officer, Listed Investments, Waterfield Advisors.

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