Owning portfolios most adaptable to change makes more sense in today’s world

People change. Ideas change, dreams change, relationships change, preferences change. These are internal changes, in the way one thinks about life and about the role of money in it. And while all this happens, the external world changes. Circumstances change, markets change, abilities change, employment and employability change, health and longevity change.

As we enter the new year with hope and optimism, we leave a year that has given us a new understanding of the scope and scale of change that can occur. We all did whatever we could to emerge successfully on the other side of the pandemic. Families worked hard to ensure that each family member had the resources and support to withstand the pandemic’s challenges. Companies re-evaluated many long-standing assumptions about their business environment and developed new ways of operating. Governments prioritized the today over the tomorrow with stimulus packages, and many struggled with the trade-off between the lives and livelihoods of its citizens.

Change is an interesting thing, like spice in your soup. Too much of it ruins the soup and makes it unpalatable, but the complete absence of it is intolerable. Like the film Groundhog Day, whose protagonist wakes up each day to encounter the exact same set of events as the day before. To some people well into a comfortable retirement, this may be familiar.

Unlike spice in your soup, however, change in your life is often outside your control. Things happen, and you respond. Darwin identified long ago that “it is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change”. How do you build a portfolio that is most adaptable to change? I would argue you would focus on building three things that any great general of an army would do—strength, agility and resilience.

The stronger army generally wins. Stories of weaker armies emerging victorious are remarkable because they are rare. Further, generally the larger army is the stronger army. Portfolios are similar in that the larger they are, the better capacity they have to weather change. People who have become wealthy in their lifetime often refer to the freedom that their wealth gives them, the freedom to spend knowing that they are unlikely to make a dent to their wealth, the freedom to take on new risks that they may not have considered before. This freedom originates from an ability to incur some losses without materially impacting their sense of well-being, their independence. A habit of prudence and discipline regarding one’s expenditure is the most proactive way to build a large portfolio, so that the money saved becomes available when needed.

Agility gives one the ability to respond quickly to change. In the face of adversity, an army that can redeploy soldiers and resources quickly and efficiently in response to a new strategic thrust is more likely to succeed. In a portfolio this is best assessed by the liquidity of its constituents. In other words, when one needs the money, how long will it take to convert the asset into cash in the bank? Also, will your asset retain its value even if you are in a hurry to monetize it, or will it surrender some of its value as a haircut? We often see such a haircut in distress sales, whether these be real assets or financial assets. One can assess liquidity by the depth of markets in which these assets are transacted. While markets like those for gilts or large-cap stocks treat sellers equally, whether in a hurry or not, markets for small-caps, antiques or below-investment-grade credits are likely to penalize those in a hurry. One can retain an agile portfolio by ensuring that it is invested in predominantly liquid assets.

Resilience gives one the ability to bounce back when struck down. An army with multiple skill sets to draw upon, depending on the context, is better able to withstand initial setbacks and still emerge victorious. In a portfolio, this is best achieved by using asset allocation to achieve balance and diversification. The ability to achieve lower levels of overall risk by including assets in the portfolio that have low correlation is well-documented. The inclusion of gold and debt may not set your portfolio on fire but will provide a cushioning effect during sharp corrections. Similarly, through geographical diversification, one can reduce the overall risk level of the portfolio without sacrificing much return.

The fact that “black swans” are becoming more frequent is a testament to the fact that we live in very interesting times. Owning portfolios most adaptable to change will ensure you can enjoy the excitement rather than be defeated by it.

The post Build a financial portfolio Darwin would be proud of appeared first on PeakAlpha.

Determine the result, ascertain its cause, assess the momentum to better predict performance

For all the talk, the pretence of knowledge, even the condescension she had got from her husband in terms of investment skill, she had beaten his pants off. Her investment had grown by 28%, whereas her husband had lost money. Here is the interesting part. Both had invested equal amounts of money and in the same scheme. The only difference was that the husband invested in February this year, whereas the wife invested in April. The husband had caught the crest of the wave, whereas the wife had caught the trough that followed a few months later. Was that skill or luck?

At the best of times, and armed with sophisticated attribution models, separating luck from skill in investment performance is difficult. Anyone who has invested across market cycles will know that some decisions that were backed by robust and thorough analysis suffered in comparison to other decisions that were made with the most cursory analysis. Having tracked the performance of mutual fund schemes and fund managers closely for 15 years, we have seen superstar fund managers from one era scrape the bottom of the barrel in another and vice-versa.

Yet, any endeavour of investing over the long term would be significantly hampered without an ability to analyze performance and draw the right conclusions. Here are some of the obvious questions that need to be addressed. First, the result—how well did your investment decisions fare? Second, the cause—how much of the result can be attributed to luck and how much to skill? Third, the “so what”—given the past, what should you do going forward? Let us look at each of these.

The result can be described in a few different ways. First, in rupees—how much money did you gain or lose? Second, as a percentage of the amount invested, or absolute return. Third, as a percentage after adjusting for time invested. Surely, a 20% return in one year is better than a 20% return in three years, right? This measure is usually called annualized return. Fourth, as a comparison to a benchmark. If one made 18% return where the benchmark made 20%, is that better than another making 16% where the benchmark made only 14%? Another way of looking at the same thing is to adjust the return for the amount of risk taken to achieve that return, something we refer to as the Greek letter alpha. We all need some measure of compensation for taking additional risk, often known as risk premium.

These measures do sound a bit like the blind men and the elephant, where they all came up with different assessments. Yet, people have many questions regarding their investments, and each measure above answers a different question. If you are looking to compare investment performance, using alpha and comparing against the benchmark are useful places to begin.

The cause is trickier, because here one needs to separate luck from skill. Timing is one of the reasons that can drive improper conclusions, as we have already seen. Further, when one is comparing two investment experiences, it is important to ensure it is an “apples to apples” comparison. Comparisons between fundamentally different instruments that are likely to behave differently are flawed, such as a mutual fund with a unit-linked insurance plan (Ulip), a hybrid scheme with an equity scheme, or a large-cap with a mid-cap. The third is to distinguish between consistency and “flash-in-the-pan” outcomes. Superior performance must be repeatable to be claimed as a skillset.

Finally, the “so-what”. To what extent can our conclusions from these comparisons be extended into the future? When is change necessary? If you are happy with the result, should you stay the course? If your results aren’t great, do you need to make changes? If our goal is to predict what will deliver superior returns in the year ahead, let us reflect on the inputs. While there are many factors, here are some to consider. The investor’s skill, whether it is regarding instrument selection, asset allocation or execution is likely to persist. The processes followed, whether they be research, investment or risk management, are also contributors. However, it is important to assess whether the investment environment has changed. If so, what worked in the past may not work in the future. Winners in a bull market are often different from winners in a flat market.

I recommend the above three-step process—determine the result, ascertain its cause, assess its momentum—as a way to achieve greater predictability in investment performance. At the very least, it will establish a lingua franca for its discussion.

The post Understand the difference between luck and skill to assess your returns appeared first on PeakAlpha.

• If most of their money is invested in fixed-income securities such as bank deposits and bonds, over time, the returns on these will struggle to beat inflation as rates fall
• The periodic increase and decrease in interest rates is a key monetary policy measure

My 70-year old aunt is anguished every time the Reserve Bank of India (RBI) announces a rate cut. “I used to get 14% interest on my fixed deposits (FDs) at one time, and now I barely get 7%.” It is a common lament among retirees whose income ebbs with a fall in interest rates.

If most of their money is invested in fixed-income securities such as bank deposits and bonds, over time, the returns on these will struggle to beat inflation as rates fall. Retirees depend on the returns from a fixed corpus to fund expenses. If interest rates fall, they increase the draw-down from the corpus to meet expenses. If the draw-down rate is high, they run the risk of exhausting assets before their lifetimes. Alternately, to stretch their corpus, they reduce expenses, which can affect their quality of life.

The periodic increase and decrease in interest rates is a key monetary policy measure. Typically, interest rates are increased to curtail inflation and vice-versa. The current low rates are a measure to encourage borrowing, spur business growth and increase consumer spending. However, sustained low interest rates hurt retirees the most, since their capacity to earn fresh income is limited. Low returns on fixed-income instruments is akin to a pay cut for senior citizens.

As our economy develops, we will see more rate cuts. Many European countries have negative rates and several developed countries are at sub-3% rates. But one must also keep in mind that even though interest rates will continue to fall in the future, so will inflation. The high inflation rates seen in the past are unlikely to play out in the future. Hence, the real return on our investment (the difference between nominal return and inflation) may not be affected to the extent of the fall in interest rates.

Here’s how to make the best of a low-interest environment.

1. If you are a business owner, you may consider increasing your borrowing since loans will now come cheaper. You can even ladder your loans by borrowing at the current low levels to pay off older, higher-interest loans. As a retail investor, you can avail cheap property, car or personal loans. You can also refinance existing, expensive loans to cheaper ones.
2. Invest in alternate assets such as gold. Gold, typically, does well when borrowing cost is low, money supply is high, the economic outlook is uncertain, and equity market is volatile. However, be wary of investing in gold when the prices are already inflated. Have systematic investment in gold across the year, so you catch the low prices along with the high. Having at least 10% allocation to gold helps manage portfolio volatility better.
3. It is important to allocate a part of your portfolio to equity to beat inflation and taxation over the years. However, increased equity exposure could make the portfolio volatile in the short term. High volatility may be palatable for someone young, who has higher risk-taking and income-generating ability, but could make an older, risk-averse person quite nervous. Working with an adviser will help determine an equity allocation that is consistent with your risk appetite and future cash flows. Even conservative organizations like the Employees’ Provident Fund Organisation are now allocating a part of their portfolio to equity to beat inflation and generate higher long-term returns.
4. Interest on FDs attract tax slabs, which can be steep if you are in the highest tax bracket. However, investing a part of your portfolio in safe, high credit-quality, short-term debt funds can offer better tax-adjusted returns. If you redeem after three years from debt funds, long-term capital gains set in, which are taxed at 20% after indexation. Short-term gains are taxed at marginal rate.
5. A rupee saved is a rupee earned. If you need to generate regular income, consider systematic withdrawal plans (SWPs) from debt funds, which are more tax-efficient than FDs. If you invested ₹10 lakh in a 7% FD, you’ll earn an interest of ₹70,000 on which you would pay tax of about ₹21,000 (assuming you were in the 30% tax slab). If you invested the same amount in a debt fund, which also grew at 7% and you withdrew ₹70,000 after a year, your capital gains may be less than ₹5,000, on which you will pay a tax of ₹1,500, for the same tax slab. This is because the withdrawal in a debt fund is a combination of the principal and the gains, which reduces your tax bill, as opposed to the entire gains.

“That Senior-citizen Welfare Plan you recommended has saved me a heap of money in taxes!” exclaimed my aunt, who had just filed her returns last week. I briefly considered correcting her abbreviation of SWP, but her understanding of it was spot on. I smiled and left it at that.

The post It doesn’t always pay to bank on fixed deposit appeared first on PeakAlpha.

How long can their existing assets carry them? And if it does not stretch until the end of their lifetimes, what can they do to ensure they have money at the end of their lives and not life at the end of their money.

Increasing income and savings is crucial for those who don’t have adequate assets.

Can’t I retire today?” asked a despondent X who had just been told by his employer that his salary would be indefinitely reduced by half the following month onwards. He was convinced he may lose his job soon and had lost all motivation to work. The covid-19 pandemic has caused many to feel insecure about their employment. For those who have already lost their jobs, finding new opportunities look daunting. So, the most common question I get asked by my clients is if they could be financially independent if they did not generate any income henceforth.

How long can their existing assets carry them? And if it does not stretch until the end of their lifetimes, what can they do to ensure they have money at the end of their lives and not life at the end of their money. Essentially, there are four financial planning levers that you can tweak today to influence future outcomes.

Increase income

If you can increase income by moving to a new job, negotiating a raise or supplementing your existing income, you provide yourself the ability to save more. Enhanced savings that are invested in line with your asset allocation enable you to reach your target retirement corpus sooner and, hence, retire faster. If you are already retired, even a part-time job with a small income can support your expenses. This additional income can then reduce the monthly draw down from your portfolio, allowing the retirement corpus to grow and compound for a longer period.

Increasing income or enhancing savings is especially crucial for those who have not created adequate assets and retirement is a mere touching distance away. However, it is also true that if you are at this stage of your life, you probably have the highest propensity to save. You may be at the peak of your income-generating capacity, and major expenses such as children’s education and home loans may have already been paid down. It is time now to hunker down and focus on building that retirement portfolio that will allow you to live your present lifestyle well into your retirement. You may not want to holiday in Nandi Hills after retirement when you enjoy the view from Mount Etna a lot more.

Reduce expenses

If increasing income looks unlikely in the current circumstances, you can reduce expenses to boost monthly surplus. This way, you increase the amount you save and invest each month and stay on track towards your retirement goals. However, knowing how much to invest, the tenure and return on investment is crucial to building your nest-egg. True that you are sacrificing current consumption for future gratification, but you will be thankful, especially if you are 70 and staring at a bank balance that barely funds a year of expense.

Extend working years

Most of you do not like the sound of it. It is also an option that you have the least control over. What if you are unwell and are unable to work? Or your employer does not postpone your retirement? Or you are unable to find suitable work after you retire?

If you have gotten off to a late start with respect to your investments, you may not have much choice but to pursue this option. Most of us should plan for a life expectancy of 90 years. If we retire at 50, we need to have saved enough to last us for another four decades. If we can push our retirement away by a few years, we allow our money to grow and compound for a longer time. The corpus will also need to fund expenses for a shorter retirement.

Reset asset allocation

Each of us has a specific allocation between safety and growth in our portfolios that enables us to reach our goals in the most efficient manner. It could be 20:80 equity to debt for some or 80:20 for others. If all the above levers are not viable to build your nest-egg in time for retirement, do consider tweaking your asset allocation to make it more aggressive. Of course, increasing the proportion of equity in the portfolio will render it very volatile in the short term. However, over time it helps compound your money faster. This is my least preferred lever, but if you have no other option, go for it. Ensure you have adequate money to meet short-term requirements, so you don’t need to dip into the equity portfolio to meet expenses during the accumulation years.

The good thing about structured financial planning is that it lets you peep into your future. If you find the future looking bleak, tweak one or more of these levers today and achieve your desired outcome for the future. Next time you want your fortune predicted, don’t go to an astrologer, make an appointment with a financial planner instead.

The post Four levers that can control your financial future appeared first on PeakAlpha.