In times of unnatural exuberance there are irrational forces that pull on an investor's portfolio. These may either be in the form of structured or unstructured advice or the psychosis of being left behind or the tug to outperform given the overtly optimistic situation. These forces create imbalance in a portfolio and lead to problems of concentration or of over leverage.
If unnatural exuberance is true, the opposite is also true. Irrational pessimism can also lead to feelings of over caution and being overtly defensive. The portfolio can be influenced by an apocalyptic fear. It clings to any sign of stability even at the cost of growth. These fears too create imbalances in a portfolio, and disable the portfolio to benefit from an imminent turnaround.
While both the above examples are of extreme situations investors are known to also swing moods during extreme volatility or even flat markets; which probably leaves us with a market that neither goes up or down for sanity to return.
Blaming the market for such behaviour is probably mistaking the wood for the tree. There are no easy or readymade answers that could solve all or even most of our queries. What is needed is a robust process that enables an investor to plan, execute and monitor her / his asset allocation depending on his unique requirement.
But planning for creating substantial wealth requires an understanding of the asset allocation practice.
Consider that no asset class (be it gold, stocks, commodities, real estate) has singularly outperformed over the long run, whether it was the bond funds that did their best in 2000 and 2001 or if we consider the mid-caps in 2002-2004 or the Sensex in 2005 and 2006.
Asset allocation is the process of deciding how to distribute wealth amongst various asset classes and sectors. Although often regarded as a minor investment decision, asset allocation is the cornerstone on which the entire investment process is built. About 90 per cent of change in returns over time can be explained by asset allocation decisions. About 40 per cent of the differences in returns can be explained by differences in asset allocation. Asset allocation is thus the major factor that drives portfolio risk and return.
There are many ways of achieving a correct portfolio strategy with diversification acting as the guiding principle. However, diversification as a concept has existed for long in the minds of investors. Many of us would know about the perils of putting all the eggs in one basket. Therefore, more than the idea of diversification, it is important to arrive at an objective method of scientifically diversifying in order to obtain the most efficient risk-return combination. The science is to select the portfolio which either holds the least amount of risk, given the return or to take the best possible return, given a level of risk.
An asset allocation recommendation requires an in depth understanding of the client and his family. The rigour of the process starts with a meeting between the advisor and the client.
The advisor tries to assess the tolerance to risk and appetite towards risk that the client possesses. Since risk tolerance and appetite form the cornerstone of building the asset allocation, the questionnaire is of utmost significance. A structured interview approach is required for profiling the investor's broad details about existing investments, approach towards liquidity, leverage etc. along with specific constraints. These help the advisor assess parts of the investment psychology that may have been implicit and not obvious otherwise.
Armed with this deep understanding the advisor is able to map the investor and is therefore able to add value while determining the yield (net return after tax) preference. S / he is then able to look at the various portfolio combinations and together with the investor arrive at the right mix. As a prerequisite for this, the advisor needs to have an in-depth understanding of the various asset classes as well have the wherewithal to offer these to the investor.
The portfolio construct must also allow for tactical allocations. The objective of tactical asset allocation is to move among various asset classes within a risk-controlled framework and to seek to create an additional source of return.
The investor might well be advised to insist on the structured process being followed and resist deviation from the plan. S / he must also insist on the various options available for her/his investments. This also puts the onus on the investor to allow the advisor to have a holistic picture of the portfolio.
Agreeing to a plan that combines various asset classes, ruthlessly executing it, and diligent follow up might not be as glamorous as talking about your latest leveraged small cap bet. It is a bit dour instead. But it's a bet that has the best odds of success in good times and times not so benign. With your money I wouldn't settle for anything less.
The author is the Head of Wealth Management & Executive Vice President at Kotak Mahindra Bank Ltd.