Economies & markets are always in state of instable equilibrium. Each factor not only affects other elements, but also gets affected back in return. Such constant evolution in in the socio-economic weather of the financial world, keeps presenting investors with new set of challenges. Each investment mistake costs money & accumulated losses over time may get too big to recover from. Thus, lack of knowledge may prove to be dangerously life altering.
The only way to minimize investment mistakes & to accelerate the progress towards financial freedom is to educate yourself. Financial education shortens the learning curve as one gets to learn from mistakes & experiences of others, without having to commit the time. Finances are just too important to be left to chance & investing in financial education certainly pays dividend over lifetime.
Asset allocation aims to apportion a portfolio into the main asset classes – equities, debt, gold & real estate – in a ratio that best serves the financial objectives of the investor. Each asset class is different in its’ risk-return profile & how it behaves over time.
Research indicates that at least 90% of the variance in a diversified portfolio’s returns is attributable to asset allocation. So, the decision regarding the combination of asset classes that is the best fit to the jig saw puzzle of various financial goals, different time horizons & risk profile, becomes an extremely important one.
The golden rule of investing is to primarily focus on finding the most suitable asset allocation because micro managing individual investments in different asset classes is an effort aimed at improving the remaining 10% contribution to return.
Successful investors focus on the factors that are in their control so that profitable outcome is achieved irrespective of the circumstances. All investment, business, & life decisions are a bet on an unknowable future & outcome is always going to be uncertain.
Expectancy Analysis is the scientific way of managing the risk of unknown. Mathematical expectation of any financial decision is the difference of the gains of correct decisions & the losses of incorrect decisions, multiplied by the frequency of correct decisions. In other words, it is probability multiplied by payoff.
In all the uncertainty, it is the payoff dimension of mathematical expectation, that investor has most control over. This ‘risk of unknown’ can be converted into an opportunity if negative payoffs (losses) are controlled tightly & gains from winning decisions are maximized. The relative size of losses & gains matters more than the number of losses or gains. It is this tilting of payoff portion in favor of investor, that produces reliable profits in an uncertain environment, even if number of incorrect decisions are far more than the correct ones.
The golden rule of investment is to focus on the payoff portion of expectancy with persistence & discipline. As sample size of transaction grows, success becomes inevitable. The expectancy equation determines the compounded rate of return & hence, the pace of wealth creation.
Risk management refers to the process of identifying potential for loss, quantifying it & taking precautionary steps to reduce such risk. It is the guardrail of investment process & its’ primary purpose is to ensure that loss is contained within acceptable limits. This process of reducing odds for losses, is essential to achieving consistent profits in different market conditions.
Risk Management entails cost that drags down the returns during good times but when investment environment turns hostile, it could prove crucial in preventing a life changing loss. The golden rule is to acknowledge that risks, including extreme event risks are a possibility & need to be managed.
The various strategies to manage risks are
- Diversification in ‘source of return’ – Speculating on interest rate movement in debt segment & on equity prices, has same source of return even if debt & equity have inverse correlation as asset classes. It is the inverse correlation between ‘sources of return’ that prevents extreme negative volatility at portfolio level.
- Before an investment is initiated, its’ divestment should also be planned for.
- Anything that hinders investment liquidation should be considered a risk, including outlier circumstances. Thinly traded stock is as risky as junk bond as far illiquidity as a risk, is concerned.
- Rebalancing of portfolio by switching from
- High volatility, high beta investments to lower volatility ones.
- Expensive valuation to better quality investment with reasonable valuation.
- Use of money market debt & cash, when investment options do not fall within the guardrails of investment process.
Goal Based Approach
Goal based investment is a framework where a portfolio is built to achieve a particular financial objective, as against focussing on maximising total portfolio return. This approach firmly puts achievement of life goals as the core objective of the investment activity, rather than the management of volatility & return. Commitment to financial goal reduces impulsive decision making & keeps financial planning aligned to real-life constraints.
Goal based process involves listing out specific, time bound, practical & measurable goals. It forces an investor to prioritize various goals, leading to better allocation of financial resources, based on necessity & time horizon. It may also force the investor to face up to life choices, that are more aspirational than high priority. This process includes periodical evaluation of the progress towards the goal & make changes, if required.
Goal based approach is the key to successful investing because the focus on a single purpose & data-based improvements, aligns the investment activity with core values of the investor.
An investment plan outlines the purpose, mode & time duration of the investment activity, so that the financial objectives are met smoothly. There is nothing like a documented investment plan to bring vision & purpose to a wide range of vague expectations. To move beyond the realm of gambling (tips, stories, future predictions) to assured gains, it is essential that this plan of positive mathematical expectation be implemented with discipline.
Process of selection, return expectation & valuation of an investment are key factors that shape the entire journey.
- Fundamentals of the business, quality of management & competitive advantage are key factors for selecting an investment.
- The investment plan should take into account that historical long term stock returns may not get replicated as investing environment could be far removed from the average circumstance or outlier data may be skewing the average data point.
- Quality investment at low valuations is key to super profits. Investment should be valued on the basis of assets &/or income. An investment is attractive only if it is available below its’ fair valuation. An asset bought only in the expectation of some greater fool paying higher price down the road, is not an investment but a gamble.
- Key to returns is the valuation at which an asset is purchased. ‘Holding period return’ for equity is inversely correlated to valuations at the beginning of the holding period. So, if investment is made at above average valuation, then expected return over next 7 to 15 years is going to be lower than average, as inevitable reversion to mean takes place.
- Being aware of biases of decision making prevents a lot of expensive mistakes.
[…] Asset Allocation, goal-based approach & re-balancing should help traverse the tricky period that seems ahead. […]