How many golden eggs should go into one basket?
By Rajmohan Krishnan
There are many erroneous ways in which a grand portfolio can be laid out too thick or spread out too thin.
Multi-millionaire Varma (name changed) asked an NBFC to take care of his entire portfolio, with the understanding that they allocate funds across many direct equity investments. The NBFC, however, allocated almost 60 per cent of the money to their own mutual fund. This wasn’t due to any nefarious intentions. They just thought it made good business sense. It didn’t. In this particular case, the fund manager’s investment style wasn’t aligned with the mood of the market. As a result, a portfolio worth many millions underperformed by around 6 per cent. When the client understood the wisdom of not putting most of his eggs in one basket, he approached our Family Office for reallocation of his assets.
Meanwhile, Sharma (name changed), a financial wizard working in one of the Big Four firms, was facing the opposite problem. Spread across 150 mutual funds and products, his portfolio was being managed by around half a dozen wealth managers. At this juncture, he experienced pressing demands in other areas of his life. That, and the fact that his portfolio had become inordinately complex, made it impossible for him to know his true IRR (Internal Rate of Return). Having realised his folly, Sharma approached us to structure and discipline his portfolio.
The plights of Varma and Sharma are not uncommon amongst UHNIs. Working with visionary wealth creators, I witness the many erroneous ways in which a grand portfolio can be laid out too thick (overconcentration of assets) or spread out too thin (over-diversification of assets).
Thankfully, there are simple ways to counter both phenomena.
Most of us are aware of the need to invest in various asset classes. We have also learnt to balance stock market investments with a combination of debt and equity. Let’s go deeper. Let’s look at other simple ways to ensure that no single basket carries too many eggs:
1. Use risk assessment
In addition to diversifying into various asset classes, the UHNI is well-advised to diversify risk too. For example, if you have a great deal of real estate in your portfolio, and you know that nobody loses money in real estate over long periods of time, would it make sense to also invest heavily in debt funds? Do you really need to invest 80 per cent of your portfolio in two asset classes with no risk? Won’t it be more prudent to invest in equity despite the higher risk?
While we respect psychometric assessments that inform us about a client’s risk appetite, we find it meaningful to nudge him towards the median. A large risk-taker can think more conservatively and a low risk-taker can emerge out of his comfort zone. The latter category of clients is losing lots of money in the current market cycle.
2. Ride the bull, be ready to eject
Bullish markets and equity go together like picnics and hampers. By investing heavily in equity during bull runs, your portfolio will at worst perform 2-3 per cent lower than a top-end fund. During such market cycles, the fund does not matter, you just need to ensure that the funds you are invested into do not have lock in periods.
3. Don’t idolise fund managers
Quite often, UHNIs overinvest in one particular fund because they are enamoured by that fund’s manager. This is rear-view investing – looking at the past performance of the fund manager while investing. But market conditions change, sometimes quite rapidly. And this fund manager, who was trumping the market in the previous market cycle, might perform abysmally under new conditions. Sometimes, even highly risk-averse clients make the mistake of over-investing with one fund manager – they might forget this is akin to overinvesting in a single asset class. The result could be a large windfall or a deep dent in the portfolio.
Let’s now look at simple ways to ensure that no the UHNI is not carrying way too many baskets:
1. Don’t approach equity like a mutual fund
If you are going to invest in 60 stocks, won’t you be better off investing in a mutual fund that in turn invests in the same or similar stocks? Understanding and responding to the movement of so many stocks is a gargantuan task, even with an advisor at your disposal.
2. Minimise your wealth managers
Many UHNIs are too lenient to apply a filter on all the wealth managers that come calling. But there are grave disadvantages to buying from all of them:
• This kind of diversification is undisciplined and arbitrary. This reason itself should suffice
• Visibility into the portfolio might diminish, with many investments becoming dormant or obsolete – usually, when wealth managers move jobs, they’ll convince you to move your investments too
• You might be overexposed to certain risks and not even be aware of it. The wealth managers might be unaware too, since they don’t know where else you are investing. So they might make recommendations that duplicate existing investments. On other occasions, gains made by one wealth manager’s investments might be nullified by losses incurred in other investments. Net result: diversification increases risk instead of reducing it
3. More funds isn’t the same as less risk
There are perhaps 3 archetypal investing personalities amongst India’s fund managers, even though hundreds of funds exist. So, at the most 3 unique kinds of funds are operational in the market at any time. Three large cap funds, three mid cap funds and so on. Why then do many investors feel compelled to invest in dozens of funds? Is this true diversification? Or the accumulation of similar risks spread over different products? Investing in more than 7 or 8 products is overkill.
Overconcentration is usually the result of GREED while over-diversification stems from FEAR. These opposing emotions play dramatic roles in the mind of the individual as well as the market as a whole. End of the day, an alarming number of investments are made irrationally.
Perhaps the optimisation of your portfolio will depend on you finding your acceptable balance of greed and fear. If you can’t strike that balance by yourself, ask your friendly neighbourhood investment advisor. And make sure he isn’t getting paid by anybody else to give you loaded advice.
The writer is the Principal Founder and Managing Director, Entrust Family Office Investment Advisors