A prescription for wealth’s health

Even Warren Buffett had to learn it the hard way, no wonder regular investors are confused: what are the top hedges you need to bear in mind while putting your hard-earned money in the markets?

A question I am frequently asked by investors is: “How are we to make sense of equity investing? We get so much conflicting advice!” This question is even more pertinent now — because the last 12 months have been bizarre. We have had no period in the last 100 years in which our health has been at more risk while our wealth, in general, has been, seemingly, less at risk.

While it is pretty simple in health terms to be safe (get vaccinated, wear a mask whenever out, etc), financial complacence is a disease which is infinitely harder to prevent and almost impossible to cure.

Let us take a stab at reducing complications and increasing awareness about risks relating to your wealth and what precautions you should take — so here’s a primer on safe investing.

Asset allocation will determine most of your returns

Asset allocation basically means your investment pie chart is strategically diversified across various available asset classes. It is not just the best thing, it’s the only thing. If you are just going to be a single asset (largely equity) player, then you are generally going to have a roller-coaster ride in your net worth — and, obviously, in your mental well-being.

There is research establishing that correct and tactical asset allocation can determine as much as 90 per cent of your overall eventual returns, with plenty of corroborative examples. For instance: post the 2000 tech crash, US equities halved. It was one of the worst periods of wealth destruction in recent history. However, in that very same period, a number of other asset classes, including gold, oil and US treasuries, delivered significant positive returns. Did you ever hear any financial advisor recommend that you should have a lower weightage to equities and higher weightage to gold and government debt? We know the answer already!

The general refrain you will hear is: keep buying equities. The reality is: across different periods of time in financial history, different asset classes have delivered vastly different returns, even in the very same period. In the period 2003 to 2005, commodities delivered vastly better returns than US equities. And in 2021, industrial commodities have outpaced global equities by a substantial margin. In this very period, US bonds which had a stellar 2020, have been absolutely decimated this year with the sharp rise in bond yields.

The reason for this “equities are the only thing” advice, is simple: nobody in the business of fund management or financial advice makes much or any money by recommending investments in government securities, gold or even commodities. The maximum fees are for recommending equity. “Remember XYZ stock I told you about three months ago? It is up 80 per cent since!” Sounds like familiar party conversation…or something that you watch financial channels for? If your end game is to have fun discussions at parties, this is fine. But if your purpose is to protect and multiply your wealth, or to optimise your portfolio, you are frankly approaching the problem from the wrong end. Specific stock selection, which eats up most of your/your adviser’s waking hours, contributes only 10 to 15 per cent of stock market returns.

If you are investing on your own, it does not make sense to concentrate your resources and time on individual security or stock selection. But all the talk you will hear from portfolio managers is how good they are at picking stocks and bottom-up winners. The uncomfortable point is: bottom-up stock picking is a very, very difficult art and nobody in the history of investing has been able to do it successfully for decades. Yes, not even Warren Buffet. Check out his record in the past 15 or 20 years and you will see an investor who has missed practically every single multibagger that the US market has given in this period: Amazon, Netflix, Domino’s, Google, Apple (he bought it well after it had become a household stock), Facebook, Microsoft etc.

The other extremely important thing is that getting the asset class right is a relatively simpler task than getting individual stock picks right. For an individual investor doing self investing, asset allocation should be the very first skill they should learn.

Take a portfolio approach to investing

Most investors believe taking individual stock advice — or ‘tips’ — from aggressive brokers, advisors, and, horror of horrors, from Twitter, and then implementing them on their own is the way to making big money.

That is a one-way ticket to financial ruin.

The reality is that all the big stock winners that we know of could not have been identified in the beginning. As we always say, “Making 100 per cent in a stock is skill. Making 1000 per cent is luck.” Individual stock picking is a game in which we are carried away by the stories of people who became very rich on a certain stock. But these kind of stories are extremely dangerous because they highlight something called ‘survivorship bias’ — which means that we look at the survivor of a certain kind of investing style and we find one guy or two guys who made serious wealth doing it in that particular manner while ignoring the fact that probably 99.99 per cent went bust doing exactly the same thing.

If you randomly pick 1,000 investors and they randomly pick a certain number of stocks, you are guaranteed to find one or two investors who become very rich. This is nothing but a simple probabilistic outcome but one that hides the fact that the vast majority will probably end up becoming reasonably poor.

Instead, take a portfolio approach to determine your equity selection. The way to find these multibaggers is to carefully select at least 25 reasonable stocks, divided into various buckets of risk and potential return. Assuming you have done some basic risk management and diversification such that you are not exposed to the vagaries of just one or two industries, at the end of a certain finite period of time (say, one or two years), 10 or 20 per cent of your investments would have become good winners while the majority will be delivering market returns. Anything between 10 to 30 per cent may also be losers.

Approach this exactly like you would approach a cricket team selection. Eliminate your bottom performers and fill those spaces with the next crop of companies you come up with. Again, after a certain period of time, you will find that the same/near-same initial list of stocks has continued to perform very well. Those are going to be your multibaggers and it is at that point that you can increase your allocation to them slightly more than where they started out from. Those are going to be Sachin Tendulkars or Diego Maradonas of your portfolio. You get them by a systematic selection process, not by a brain wave.

Biases come in our way of making rational decisions

There’s a long list of biases humans suffer from. Storification bias: relying on anecdotes more than data. Recency bias: recent events unduly influence our decisions rather than events that happened earlier. Herd mentality: If everyone is saying the same thing, it must be right.

Each one of these can be tracked down to an evolutionary reason. For example, in hunter-gatherer tribes, chances of survival were higher if one moved around in groups rather than alone. Hence herd mentality became a way of life and of survival. Unfortunately, the traits that helped us survive the threats of physical environment are the same that lead us to financial suicide.

Any investor would do well to ask their financial advisor how do they avoid falling prey to these biases, and safeguard their portfolios from them.

Chew on the risk management pill daily