Managing Individual Investment Portfolios Better

This article attempts to explore issues in portfolio management faced by individual investors. Good portfolio management calls for appropriate benchmarking in-order to assess performance. Portfolio performance could be improved when individuals posses a nuanced understanding of financial markets. However, with the information deluge today this understanding is inadequate and sometimes faulty. We reiterate the importance of maintaining purchasing power in an economy prone to high inflation. We also explore some common biases and other elements detrimental to portfolio performance.

How well are individual investors informed?

The individual investor’s environment is a hotchpotch of influences: misleading advertisement, enticements, incentives, hidden costs, ‘expert’ advice and institutional fads. Unfortunately few of these influences have covertly crept into publications and formal finance. The whole gamut of fads and misconceptions – IPO investing, NFO investing, goal-based investing, passive investing, small-stock investing and others – deserve a separate discussion. We need to question the efficacy of these investments which are driven by the profit motive of institutions.

Investors come in various shapes or rigidity in thoughts. The arithmetically agile coincide with arithmetically novice: those who comprehend nominal return but not real rate of return. A majority of investors who have similar traits, for lack of a better term, we shall call – the able but misinformed. This cohort form an eclectic group – doctors, engineers, teachers finance professionals, and even business-owners. The misinformation that they encounter every day come from the deluge of news, tips, behavioural biases, unstructured thinking, wrong guidance and a lack of basic understanding of financial markets.

How to improve market understanding?

The able and misinformed use heuristics, rules of thumb, in an effort to come to terms with financial markets. Unbeknownst, they succumb to erroneous conclusions. For example, many well-intentioned investors consider good to buy low-price stock or 52-week lows – wrongly equating low price to cheapness in value. Buying stocks after it has split on the belief that it might regain its pre-split price – as though it ought to.

One reason for a faulty understanding of markets is attributed to imposing of prior education and experience in an unrelated field to the former. For instance, the desire to view markets as a cause and effect system. A linear one leads to the other view.

However, financial markets do not resemble closed circuit systems. No negative and positive forces cancel out each other. No momentum until acted upon situations exist.

Maybe, the underlying structure of financial markets is an engineering problem: the computers, networks, checks-and-balances. But asset prices – equity prices, real estate prices, lending rates, gold price, exchange rate etc – are determined by a mix of economic and psychological factors.

Prices are influenced by long-term expectation of future economic growth and its components such as interest rates, inflation, productivity levels, tax rates etc and the impact of these on the earnings of the underlying asset. Asset prices trend near their fair values: the sum of discounted future cash flows expected from that asset is its fair value.

One would expect that a business owner – someone familiar with the pattern of risks and rewards – would be well-disposed of investing nuances.

During the course of a discussion with one such business owner, he explained his industry dynamics – customers, suppliers and competitors – the business cycles he has experienced over decades, the near-bankruptcy situation he has endured, the importance of saving capital in good times, the need to stay in the industry in difficult times etc. In the same breath, he shared his experience of investing in stocks and mutual funds. We noticed the following biases;

  • impatience with portfolio performance and excessive worrying
  • excessive reading-the-tape phenomenon
  • lack of a genuine investing philosophy
  • panicky when there was bearable market volatility
  • heavy-weighing tips against mundane facts and figures
  • extreme distrust toward money managers without verifying data

On the last point, when confronted with historical data of the track record of few money managers the results uncomfortably surprised him.

The wide chasm in strategic thinking between business and private investment in the above instance is stupendous. He was his biggest investing enemy. His business-like approach should have been extended to investments – long-term thinking, capital protection, contrarian buying. Instead, he chose to follow the herd. He also succumbed to salesperson’s coercion of frequent portfolio churning and other such enticements.

In general, the destruction in portfolio returns is as much carried out by the investor as much as it is a bad investment. If you are not fortunate enough to see any alpha in your portfolio it’s not the same as concluding that alpha is not produced by the market or even by the fund manager. It’s just that the alpha is in someone else’s portfolio.

There ought to be clarity on the nature of an investment contract. Trusting your funds with a fund manager or with capital-allocators (such as companies) is not a contract in the usual sense. It’s a soft contract. The manager/allocator deploys funds in economic activities whose value is dependent on unpredictable future events. It is not the same as hiring a civil contractor, a mechanic or a doctor to solve two or three-dimensional physical problems. Appreciating such nuances help the investors better coordinate decisions with his advisor and build a longer relationship rather than a shoot-and-run kind.

What is the ideal hurdle rate for investments?

The function of money is retention of value apart from acting as a facilitator of transactions. Central Banks conduct monetary affairs in such a manner that the currency’s purchasing power is preserved. The erratic loss of purchasing power as a result of inflation is a harbinger of distrust in governments and central banks. It leads to corruption, lower taxes to the government, lower standard of living for citizens and a seeds parallel economy. Corruption is a moral hazard as it discourages honest entrepreneurs from taking the necessary business risks. All these precipitates a slowing economy.

The purchasing power of money is a simple yet vital concept. It’s the ability of money to buy the same basket of goods year after year after year. For instance, if a hundred rupees fetches you five oranges today and it remains to fetch you five oranges, or nearly the same quantities, one year, two years or three years on then it’s said to retain purchasing power.

PURPOSE OF INVESTING IS TO SATISFY UTILITY

A common objective of all private investment portfolios is to ensure retention of purchasing-power. Individual portfolio performance needs to be weighed against price-rise of consumable goods. Consumption is an ideal benchmark as it satisfies a need or a utility. An investment today entails postponing a utility to tomorrow so that a greater volume of utility can be enjoyed. The bridge between today’s portfolio and tomorrow’s price of a basket of goods – which satisfies tomorrows utility to a greater extent – is the desired return.

A look at how idle-money loses value in the long run

Is it desirable to just hold money in-hand and not invest? An analysis of historical inflation trends reveals interesting details. The combined effect of inflation over the last ten years leaves a hundred rupees in cash at the beginning of the year 2005 worth only thirty-eight by the end of cal-2014. That’s a whopping sixty-two percent purchasing power destroyed! There is near-certainty that such loss is permanent. The destruction could slow in pace or quicken over the next few years, but chances of reversal are remote. An analysis of the last twenty years shows that seventy-seven percent of the purchasing power of initial money value is destroyed.

You may notice the difference in purchasing power destruction between the two time periods and wonder about the magnitudes. The analysis is derived using real data. Inflation trends behave erratic – sometimes cyclical but never linear and smooth. The analysis of historical inflation effects on currency paints a picture of both unpredictability and severity.

The worst sub-period in recent times is the post global financial crisis (the post year 2008) when the seven-year period ravaged money fifty-three percent of its value. As against this the best period of the rupee retaining its purchasing power is the beginning of that decade when over a five-year period the currency retained ninety-percent of its value! Yes, just ten-percent depreciation!

The loss of purchasing power affects consumption. Investment portfolios should compensate the individual for the loss in purchasing power of money. Therefore the relevant benchmark for individual portfolios is inflation during the holding period. In an exceptional situation when purchasing power of our currency increases portfolios can afford to underperform.

How to protect our money by investing?

Investing in stocks, mutual funds or bank deposits or certain commodities are avenues to protect purchasing power. The return from these investments is expected to produce an amount in excess of the decline in currency value (real-return). Bank deposits are a cheap (low transaction cost), easily accessible, low-risk form of investment. The real-return you earn by investing in bank deposits may be marginal but it protects wholly against a decline in currency values.

A historical data analysis of inflation numbers versus the one-year average deposit rates in India shows that in fifteen out of the last twenty-three years bank deposits generated real-return. Five of those eight times – the no real return period – happened to be in the last seven years. This analogy could be extended in general to fixed-income investments of high-credit-quality.

We repeated the real-return analysis taking equities; for this analysis, we used the BSE Sensex index data as a proxy for equities. A year-by-year analysis, as we did with bank deposits, would not be entirely wrong from a consumption model. Equities showed no real-return in eleven out of the twenty-three years we sampled. This was a mediocre performance; the disappointing results reflect in generally low ownership of this asset class. In utility terms, the success ratio of equity investments contributing to your moment to moment wellbeing is about fifty percent.

An investment in both asset classes, that is equities and fixed deposits improves the results significantly. Because of the asynchronous nature of the two asset classes, the number of times both the asset classes simultaneously experience no real return diminishes significantly. Our analysis shows only four out of twenty-three times the portfolio generated no real return. In other words, nineteen out of twenty-three times the portfolio generated a real return. Therefore, a combined portfolio is more likely to deliver better utility to the investor.

Diversifying internationally

Sustained high inflation weakens the economy causing fall in asset prices: lower equities and unattractive fixed deposit rates. The exchange rate adjusts by weakening against foreign currencies. In such a situation the investor could protect himself by investing in international assets: US Equities, Australian fixed income etc. The enhanced value of international assets in the portfolio, through exchange gains, compensates the fall in purchasing power of domestic currency. This strategy protects the overall portfolio from unilateral decline.

Adviser approach must evolve

In an institutional framework clearing above the benchmark is important for manager continuity and shaping performance bonuses. However in the case of individual portfolios appropriate benchmarking remains hazy in practice. Initial risk-profiling of investors – such as conservative, moderate and aggressive – brings in ambiguity and suppresses objectivity. The practice of balkanizing investors based on canned behaviour seem quite ephemeral. The rapidity at which individual emotional faculties gyrate through the day is unpredictable and deserves the attention of profilers. There are no eternally conservative investors nor investments. An objective to retain purchasing power, maximise utility and educate investors on financial markets is a better ideal to struggle for.

This article covered few of the common investor biases that hurt investment performance. Some of these self-induced biases, untruths, heuristics and misalignment of interests put individual investors in disarray as far as an investment into market securities are concerned. The information available is plenty; what is needed to improve the performance of individual portfolios is reshaping of thoughts and disenchantment from marketing fads.

 

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