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Slow and steady is the smart way to invest

Not too many people like to watch Dravid hit single after single. At least not when Dhoni is hitting sixes. A game of boundaries is definitely more exciting than a game of singles, but that excitement is best left to cricket. Cricketers can afford to take risks and get out, but your money cannot. 

Investors often get lured by the prospect of large returns by friends, brokers and fund managers, and very often, they will see those returns in rising markets. Promises of earning 40 per cent a year sound very attractive and may come true in a given year, but they cannot sustain themselves, but disciplined investments can provide modest yet consistent returns. 

A simple example illustrates this. Investor A earns 40 per cent in one year and then loses 20 per cent the next year.  Investor B earns 10 per cent every year. Over four years, Investor A, the investor who was hitting sixes and seeing big returns earns 25 per cent, whereas Investor B who was hitting singles earned 46 per cent. 

In this article, we explain four strategies that investors can use to ensure a consistent investment performance. 

Diversification 
Diversification as a strategy has its critics, but it has stood the test of time. Critics of diversification will say that by spreading your investments across stocks, sectors or funds, you are spreading your bets too thin. You will never make meaningful returns. The truth is, by investing in a diversified portfolio in a systematic manner, it is possible to outperform the market in small, but consistent amounts. 

Diversification is also a natural form of risk management. By holding smaller positions across a large number of stocks/ sectors/ funds, you protect your portfolio from  a single stock/ sector/ fund having performing badly and one-off events such as a fraud (eg Satyam). 

So how should you diversify your portfolio? Build a portfolio selected from an index like the NIFTY or NIFTY Junior with the following characteristics:

• 50+ stocks: Typical portfolios that hold 10-15 stocks are not diversified portfolios. By holding 50+ you are giving yourself exposure to something similar to an index.
• 6-10 sectors: It is dangerous to hold two-three sectors, particularly flavour-of-the-season sectors like infrastructure and real estate. A sector can go through a rough patch because of an unforeseen regulatory change -- telecom stocks fell more than 30 per cent in October because of mandatory per second billing speculation. 
• Many promoter groups: Stocks in India across sectors can be heavily concentrated towards a particular promoter (eg Ambani, Tata, Birla). Ensure your portfolio is not titled to a particular promoter because you will then have a lot of individual idiosyncratic risk built into the portfolio.

The author is the co-founder of Forefront Capital Management (http://www.forefrontcap.com), a specialised portfolio management services firm providing equity investments based on quantitative portfolio construction. She can be contacted at radhika.gupta@forefrontcap.com.

Bluechip stocks

Large-cap versus small-cap like diversification is a pretty widely debated topic. While it is acknowledged that small-cap stocks on average provide higher returns, the higher returns don't come for free. Small-cap stocks come with significantly higher risks, that retail investors are often unaware of. 

Does this mean you should hold just the 10 largest stocks in the country? No. A long-term investor looking for consistent performance should hold a mix of large and mid-cap stocks selected from indices like the NIFTY, NIFTY Junior and BSE100. 

Why should you compromise a little extra small-cap return? Because large and mid-cap stocks will: 

• Provide you equity upside, which is what you are after. Your goal is not to look for the last percentage of return in the stock market -- leave that to traders.
• Are relatively better known and understood. It is easier to follow your investment and look out for one-off events that may affect you.
• Fall less in tough markets. Many managers holding small-cap stocks lost heavily in 2008 and did not survive to see the rebound.
• Are liquid and tend to remain so in tough market environments. It is easy for you to get in and out of these stocks as you need to.

Sanity check your fund manager

Would you choose a fund manager who promised you 30 per cent returns in a year or 15 per cent returns in a year? The answer is less obvious than it seems. Fund managers often show investors promises of very high returns, ranging from numbers as unbelievable as 30 per cent a year to even 10 per cent a month. These numbers may be backed up by realised performance -- but that realised performance will be a year's performance in a massive bull market.

Many investors will believe what they see, only to realise the actual performance of their portfolio is not close to what was promised. The problem: no one can deliver 10 per cent a month in the long run. The Indian market should return 15 per cent on average in the long run based on our expected GDP growth. A manager can reasonably outperform the market by 5 per cent, if he happens to be a very good one. That sets an outer limit of 20 per cent a year on an equity investment in the long run -- which is miles a away from 10 per cent a month. 

So what should you do the next time someone promises you great looking returns? Add a healthy dose of scepticism and look for the following: 

• Average expected returns on an equity investment between 15-20 per cent a year
• A track record that shows returns in bull and bear markets
• Returns that are broadly in line with competitors returns and SENSEX or NIFTY returns

Your investment innings

Holding a diversified portfolio of blue chips stocks and choosing realistic honest managers will give you a consistent stream of returns. While your returns may appear modest when compared to what friends are earning and others are offering, your performance will hold itself through the swings of the markets. Investing your money is one of the most important matches you will play -- make sure you bat through the innings.