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Why portfolio risk and asset allocation matter more than investment returns

Before discussing the potential returns from an investment, factors such as purpose, goal timelines, asset allocation and risk appetite must be understood

March 09, 2021 / 10:45 AM IST

A conversation I had a few weeks back with a friend has given me this train of thought. He was talking to me about an interaction he had having with some other friends, where there was a furious debate on which asset classes and geographies would deliver superior returns in the future. It seemed to have been an interesting debate, and had left my friend with some thoughts of his own.

As you would agree, this particular topic of debate is not uncommon at all and today’s information-empowered world has led to both more aware, at the same time confused, investors. The last 12 months have given them more reason to speculate – equities crashed and rose like a phoenix, gold has done more this year than what it did maybe a decade before and interest rates are at their all time low, with the jury out on whether the bottom has been hit. And to throw in a bit more choice, the long-inert real estate market has suddenly shown increasing signs of activity in the last few months, aided by some govt-given benefits.

In my chat with my friend, my immediate response was to mention that a debate on returns is usually an indication that there are other underlying issues that the investor seems to be ignoring. Investors usually seem overtly focused on returns and are always keen to know where to put their money next. This is especially so during a bull market, and when the recent past has given very good returns. But, excessive focus on returns is usually a function of not enough focus on a few other important, yet ignored, aspects.

In my experience, focusing adequately on these other aspects leads to enough and more clarity on which asset class an investor should choose and what returns the investor should expect for the future.

While there may be more, I quickly highlight below five important aspects that investors should seek to understand and answer, before evaluating returns.

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Purpose

Investing is a process of building wealth, which in turn is for fulfilling a purpose. Even the wealthiest person would agree with this. Hence, when you talk about the investing prospects of an asset class, you need to understand what the purpose of the investment is. What is the underlying need (or goal) for which this investment is being envisaged? What is the value of the goal towards which this investment will contribute? How important is this goal within your overall priorities?

Time Horizon

Every journey needs a destination. Similarly, every need is incomplete without a time horizon. How many years away is the goal, and in which geography is it going to be realised? How flexible is this time horizon, and can it be shifted by 1-2 years? E.g., a graduation fee payment cannot wait, while a second home purchase can be postponed.

Risk

Experienced investors would agree when I say that successful investing is more about minimizing risks than about maximizing returns. Many investors understand this aspect, but ignore it until they actually experience it. Also, risk is a subjective word, with many different interpretations. Some important risks that need to be considered are:

-Capital-loss: How high is the risk of permanent capital loss? Over what time-frame? How will that impact your financials?

-Volatility: How much will your capital gyrate in terms of value and over what time-frame? How will you react to it?

-Liquidity: How easily can the particular asset that you are considering be sold when needed? Eg. I know someone who is financially very secure but has a large portion of his assets is real estate, and has a house earmarked for the foreign education of each of his children. Now with one of them planning to go abroad a year from now, how easy is it going to be to liquidate a house to fund for the education expenses?

-Concentration – What % of your overall portfolio does this particular asset and asset class account for? Do you have adequate diversification within and across asset-classes?

Every investor has a unique Risk Profile, which articulates their attitudes towards Risk and is an outcome of how they would react to some of the risks above, especially capital-loss, temporary or permanent, and which therefore determines what an appropriate asset allocation would be for them. Which brings us to

Asset allocation

Asset Allocation may seem to be a technical word to many, even abstract, but all it means is having the right proportion of investments across multiple asset classes, which can help you reach your financial goals with minimum risk. Regularly monitored asset allocation acts a “thermostat”, if you will, on an over-heated (i.e., higher than required risk) portfolio, thereby ensuring that your destination is reached in time with the minimum possible interim risks.

Hence, while you may be a very aggressive investor in terms of risk profile, in case your asset allocation does not need you to take more risk, you would be wise not to, since your existing portfolio will help you reach your goals without adding any further risk.

Source of advice

This is important because, while good information is freely available, it may not necessarily be good advice for you. Even if it is pertinent, well-researched advice, be sure that the person giving the information should have an interest in your financial well-being and nothing else.

Some of these questions above may seem unnecessary, even childish, for some. This is all the more so in raging bull markets such as the one we are experiencing now, when every day that you stay out increases the sense of FOMO (fear of missing out). But in my experience, asking these questions, however superfluous they may seem, does two things:

-brings tremendous clarity behind why you are envisaging a particular investment; and

-importantly, prevents you from taking hasty investing decisions which could cause regret later.

So, the next time you are in a conversation about investments and which ones are more suitable forward, remember to chip in with: “it is not only about the returns, silly.”
Girish Ganaraj
first published: Mar 9, 2021 10:35 am

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