Segment 1: Approach markets with a portfolio perspective

You would have noticed when you browse financial sites, pretty soon advertisements come in saying ‘How one stock can change your life’, ‘Made xxxxx amount in a single trade’ and always there is the fancy car or lifestyle at the background. And this is not limited to these advertisements. On financial channels, while they do serve a good purpose in terms of giving information and analysis on the economy and companies, the downside is this fancy of trying to seek out multi-baggers and obsession with beating the market.

Multi-baggers, ‘One stock can change your life!’

In the case of identifying multi-baggers, all the respected market participants explain that one does not know whether a stock becomes a multi-bagger or not when one buys it. Economy and markets are dynamic and it’s over a period of time, that the potential is recognized. However, for most people, this voice of sanity is not heard but their eyes fill up with dollar signs as they hope that the stock they buy would be the next HDFC Bank. Again the ‘one stock can change your life’ advertisement comes roaring back and thoughts of fancy cars and lifestyle gets one beaming and buzzing.

Beating the market or a Risk adjusted Return

There is another obsession and that is one of beating the market. Historical evidence of developed markets clearly show that one cannot consistently beat the market. But what is required is that you focus on getting a decent risk adjusted return (RAR) from the market on a consistent basis. Now what is a decent RAR and let’s see one way of calculating it.

Calculating a Risk Premium

What is this risk premium? It’s similar to why longer-term FDs give you more returns than a near term FD. One is longer the holding period, the higher the risk. So, more returns should be expected. Second, riskier an investment, higher the return you would want. Thirdly, a personal risk premium is accepting the fact that one does not know everything and that we are bound to make mistakes.

There are many ways in which we can compute a risk premium. One of them is shown below. Today the return that one should reasonably expect can be considered as follows:

Not an exact science

Rather than looking to beat the benchmark yearly, one should look to achieve a consistent RAR on their portfolio. Now these factors change and adjustments should be made. RBI Repo rate changes with time and the RAR would change. The premiums are not constant. One person’s risk premium may be different from others. And the figures given above are ball park figures and not an exact science. But it does give you a framework which one should use when considering investments.

Compounding

The bottom line is one should focus on generating wealth over a period of time and to let the miracle of compounding do the work for you. Now keep in mind that equity markets are volatile, and you would not get a smoothed year on year appreciation as FDs would. But over a period of time, an annualized RAR should come in. Below, we have depicted on a base of 100 the miracle of compounding. Note that after a 10-12-year period, the returns get exponential.

Greed

Unfortunatley, what most people hope when they come to markets is to get exponential returns immediately. And that hardly ever works because of the inherent nature of markets and human folly. There is a strong relationship between risk and return. Outsized risks can destroy you. The human folly here is greed and that craze for a huge return in a short period of time causes you to take highly risky positions, many a time with leverage and can competely wipe you out.

Stay the course

We have all learned the childhood tale of the ‘Hare and the Tortoise’. Slow and steady wins the race. Applicable in life as well as in markets. All of us know instant gratification is not sustainable. But that’s the fad and the craze and we all fall for it. But the key is to understand the dangers of these distractions and stay the course with patience. Peer pressure or herd mentality is another factor that can cause you to get distracted. When others talk of the millions they are making or in markets FOMO (fear of missing out), its important to stay focused on the course.

A portfolio approach

Now this brings us as to why we should have a portfolio approach rather than just some haphazard buying of stocks or assets here and there. Research indicates that one of the most important factors of return is Asset Allocation. This refers to the various combination of asset classes like equities, commodities, bonds, currencies etc. This is because there is an inter relationship between various asset classes. And money flows into these various asset classes based on economic expectations. For example, when inflation is a concern, there is a shift from bonds into commodities. Or when economic outlook is good, there would be a higher allocation to equities. So, depending on the economic outlook, the overall asset allocation of the portfolio changes.

An equity portfolio structure

Focusing just on the equity portfolio, one of the ways to structure a portfolio is to divide it into 5 economic components that drive an economy.

·      Consumption

·      Credit

·      Investment cycle

·      Digital/IT

·      Exports

In the next segment, we will dwell a little more on structuring the equity portfolio along the lines given above.