As an adviser, we get to interact with clients at various stages of investor maturities. While some clients are beginning to build a portfolio, others already have one. In the process of giving clients investment advice, the first part of our job is to unwind their complex portfolios before we build them one which is suitable to their preferences, capacity, and requirements.
Unwinding complex portfolios built over time has been a learning in itself. Each portfolio carries a history of the trends of:
- popular knowledge around investing at a point in time,
- the incentives of financial salespersons in different eras,
- the losses suffered by investors when big market events happen, and
- the familial conclusions of investing pressed upon the next generations and more.
Different portfolios have many minds behind them, yet they all carry some common approaches that have been summarized below. These are stages all new investors (and especially DIYers) go through. By understanding these approaches a lot of experiential learning can be bypassed and a long-lasting portfolio can be built from the very first go.
Whether you are a new investor or an experienced one, building a portfolio is a steep learning curve. It works in your favor to approach investing as a newbie, every day.
Approaches to Investments
We have found 3 approaches to portfolio building common to most investors. These are:
- Instruments Approach
- Returns Approach
- Goals Approach
We will discuss these approaches so that we can share our learning about what works or does not work using them. A determinant of which approach an investor may be using is the investing vocabulary they talk in.
Investment instruments are contracts that define the scope of the investment in terms of time, parties, obligations, guarantees, and so on. Investors following the instruments approach get into different contracts made available to them and associate specific outcomes (like appreciation or preservation) and characteristics (capital guarantee or coupons) with these instruments.
Investors choose from Stocks, Mutual Funds, Fixed Deposits, Futures and Options, Bonds, NCDs, ULIPS, Crypto, Bullion, Commodities REITS, Pension Plans, Tax-saving, etc.
This makes them speak in the vocabulary of such instruments. Typically such investors talk about:
- DMAT Accounts, Brokerage, Trading Accounts, Shares, or ETFs.
- Large Cap Funds, Mid Cap Funds, Small Cap Funds, Corporate Bond Funds, Liquid Funds, etc.
- Commercial Property, Residential Property, Plots.
- Gold Coin, Gold ETF, Sovereign Gold Bonds.
- Bitcoin, Ethereum, etc.
An instruments approach makes investors always look out for new and innovative ways of investing. In the process, their portfolios become a collection of simple & complex instruments from various eras of investing. In the beginning, such investors fall prey to unscrupulous financial sales person (who may not essentially have bad intentions, but have poorly designed incentives) and fall into long-term commitments of complex instruments.
If a financial instrument tries to serve more than one function in a significant manner, then we can call it a complex instrument. This means that if an instrument tries to serve future consumption as well as act as a buffer at the same time (or any other combination), we can classify it as a complex instrument.Page 143, Chapter 15 “Everything Has a Purpose”, “What My MBA Did Not Teach Me About Money”
Such instruments carry more than one feature in the same contract, such as insurance, tax-saving, and investment appreciation all in one go. While these are attractive to naive investors because of their seeming convenience, they are a boon for the financial salesman because of the ease of marketing and the built-in hefty commission structure. Consequently, we find a lot of complex instruments in self-made financial portfolios.
After a few years of paying heavy (and often hidden) commissions, investors following the instruments approach feel betrayed by the financial sales community and usually develop a general mistrust of it as a whole. Yet, they keep pursuing the next shiny thing and are still a sales target of better stories. It is not that the investors themselves wish to create complex portfolios, it is just their approach that leads them to this end result. Complex portfolios often run into crores, since they are a result of decades of instrument collection.
Once in a while, there will be investors who are completely focused on one type of instrument (such as mutual funds only or stocks only). They have an unusually large collection of the same instrument because they have become comfortable with it (mistaking it as expertise). Such portfolios are exhausting to manage and end up becoming a living being too difficult to converse with (rebalance & reallocate).
What we learned
Instruments are tools to create portfolios for investments. Instruments are not the investment themselves. The underlying asset class of the instrument is the real investment. The instrument is the means to provide exposure to the underlying asset class or the sub-components within the asset class.
A shift in perspective from instruments to assets makes a great change in creating portfolios.
Different asset classes are:
- Cash or Cash Equivalents (the often ignored and the most important one).
- Fixed Income (Debt)
- Currencies, etc.
When the investors’ approach shifts from instruments to asset classes, they look for the most efficient instrument to participate in an asset class. This leads them to bypass complex (multi-purpose) and expensive (there is always an extra-thick cost for the added convenience) instruments and focus on simple ones.
A good number of investors start their journey from a different perspective.
Investors simply want the best investment options.
Such investors are in the constant hunt for the Best Mutual Funds, Best Bank FDs, Best Stocks, Best Property, and more recently Best Investing Platform to invest through.
While the fresh (and often well-educated) investors talk about CAGRs, IRRs, expense ratios, and marginal increments in returns, The more sophisticated ones talk in terms of P/E Ratios, Price-to-sales, PEG ratios, ROC, ROCE, etc for equity and similar metrics for other asset classes. They also talk about costs and fees. The even more technically experienced ones talk about the institutional-grade investing metrics of Alpha, Beta, Volatility, and Sharpe Ratios.
While all the metrics are good on paper (or a spreadsheet) the human brain simply short-circuits (gives in to biases) when the investors see the result – Returns. The returns provided by the stock, the fund (or the manager), or the platform in the near term overshadow all logic previously employed by investors.
Returns are elusive. They are like the stars in the sky that may show us the way but do not tell us about the pitfalls on the way. Returns simply do not describe the journey taken by the investment manager to achieve them. Returns do not talk about the anxiety caused by the volatility which every investor faces.Page 87, Chapter 8 “The Hand of Risk”, “What My MBA Did Not Teach Me About Money”
The stock or fund or platform that offers the best returns wins (no matter what the risk metrics). In the process, investors with a returns approaches are liable to take very large risks (often unknowingly). This is why a lot of investors (most younger than others) fall prey to well-marketed double-the-money schemes. They look for the best returns and end up concentrating their portfolios on risky and unsafe investments.
What we learned
Returns are an absolute measure. When investors tell us that they are looking for 12% returns on their portfolio, we understand that their expectations are internal. It is what they want. Having internal benchmarks of returns leads them to pursue the “best” investments marketed at that point in time i.e. the returns approach. It also exposes them to unmeasured quantities of risks.
However, it may not be what the market is offering. The markets decide the returns that investors will receive in their hands. Therefore it is important to know what the benchmarks are giving.
More return in a plain vanilla investment simply means more risk being taken up.
As a rule of thumb (not established research) benchmark returns are linked to the Risk-Free Rate (RFR) and Inflation (INF) (both of which are linked to each other) in the long term as below:
- Bank Rate = RFR + 0.5%
- Government Bonds = RFR + 1%
- Corporate Bonds AAA (CBA) = RFR + 1-2%
- Corporate Bonds AA = CBA + 0.5%
- Corporate Bonds A = CBA + 1.0% and so on
- Gold = INF + 2%
- Large Cap Equity (LCE) = RFR +5%
- Mid Cap Equity = LCE + 1%
- Small Cap Equity = LCE + 1.5% and so on.
- And so on…
Instead of returns, if investors keep benchmarks in mind they are likely to create better portfolios by simply allocating what amount of each benchmark they need in their portfolio. However, this is a tough set of quantities to be determined. This leads us to the third approach investors use (and more so recently).
Goals are the best way to create focus and drive discipline in the long term. When human beings define a goal in terms of purpose, time, and value, they can achieve it much more easily than otherwise. The clear cut the goal, the easier it is to achieve because the way to achieve it can be broken down into smaller doable parts. For example, a SIP or an EMI reduces the target of a big long-term goal into a monthly manageable amount.
Investors who focus on goals may use simple instruments and talk in terms of the outcome rather than the means. Their investment vocabulary consists of:
House, Children’s Education, Vacations, Marriage, Charity, Care of elderly dependants, Cars, Handbags, Automatic watches, etc.
Most investors classify goals into two types – Emotional or Material. Emotional goals are about themselves and their loved ones or deep desires they have had since childhood (house, parents, children, etc.). Material goals are about the comparison to others (bigger car, better vacation destination, luxury, etc.)
What we learned
While being focused has its advantages, there is a very high probability that it may be misdirected. We often find individuals focused on their emotional goals and ignoring their personal futures completely. This usually happens with a (positive or negative) life-changing event that colors perspectives completely.
A positive example is the birth of a child. Parents are very emotional about their child’s future. This is a good thing. However, prioritizing the possibility of foreign education or a grand wedding for the child over their retirement is an emotional folly. While children may have a superior experience or a grand event in their lives, they may also be left with dependent parents who were unprepared for retirement. In a negative scenario, losing a childhood privilege may force individuals towards unnecessary material goals like a bigger and bigger house.
This makes us understand that goals need to be regulated and prioritized. They should not be pursued as a relief or hedonically.
How to invest if you are a newbie?
We learned three things when unwinding investor portfolios:
- Do not chase the next shiny thing and end up collecting a bunch of complex investment instruments. Instead, focus on asset classes and the risk-reward they carry.
- Do not chase returns since you may end up taking unsavory risks. Instead, find the right benchmarks and allocate wisely to them as per your need.
- Do not chase goals passionately since you may end up cornering emotional or material ones. Instead, regulate and prioritize goals.
A good portfolio needs to be constructed with simple instruments, with the right exposure, and covering the needs and desires of life. This can be done through an investment plan.
An investment plan solves the problem of agendas for the investor.
A good investment plan covers not only the wants and desires of the individual or family but also the boring yet essential things weaved into the structure of life.
By identifying different needs and defining their priority the corresponding risk-reward characteristics can be chosen. These characteristics can then be mapped to different asset classes or their combinations and executed using precise yet simple instruments.
Our research, experience, and conventional wisdom have helped us identify three themes that cover mostly everything in the lives of individuals & families. These are:
- Wealth – The investment agenda covers contingencies, saving retirement, becoming rich, staying rich, and leaving a legacy.
- Goals – The investment agenda for funding emotional and financing material goals.
- Cash-flow – The investment agenda of replacing income for basics, creating a buffer for short-term crises, and generating profits for discretionary spending.
For each individual or family, all three themes run concurrently. However, depending on individual circumstances one theme may be dominant. This too changes as life evolves.
By investing using an investment plan investors can avoid gross errors and yet they can benefit through the focus given by goals. Staying a newbie is essential to investing (humility is the most important trait of a successful investor) but professional outcomes can be achieved as well.
Looking to invest using investment plans?
To find out more about our investment plans and how we understand your Risk Preferences, Risk Capacity, and Risk Requirements to zero in on a custom plan for you start a one-on-one Conversation here: https://modulorcapital.com/start-a-conversation/
Modulor Advisory Services is a Securities and Exchange Board of India (SEBI) Registered Investment Adviser (RIA) with license number INA100015115.