Never lose money on your investments: first step towards wealth creation

If we consider a typical investor portfolio, there are three risk buckets that an investor consciously or subconsciously manages: personal risk bucket, market risk bucket and aspirational risk bucket. Now, without enhancing the performance of the personal risk bucket, it is nearly impossible to increase the performance of an investor’s overall portfolio, as it is one of the biggest and core part of the investor’s portfolio. Equity is one of the asset classes that can be considered for this purpose. However, the challenge with equity is that it also adds significant risk to the overall portfolio.

Investing can be likened to driving a car, where acceleration is similar to investing in equities. However, one cannot keep accelerating continuously as there are dangerous curves and traffic on the road. That’s why cars have brakes to calibrate speed as needed. In this analogy, brakes can be compared to fixed income investments. Nonetheless, there is still a risk that someone else may collide with your car. To handle such situations, we need to have airbags in the car. At the portfolio level, allocation to gold is required to withstand such crises. In this context, equity acts as acceleration, fixed income as the brakes, and gold is the airbag.

During volatile periods, fixed income investments act as volatility controllers, while during any critical situation like the subprime crisis and covid pandemic, gold acts as a volatility absorber. Its prices appreciate dramatically during such times, thereby helping the portfolio absorb the shocks.

Combining asset classes through multi-asset strategy is necessary to optimize return at given level of volatility.

Various asset classes have a varied degree of correlation with each other. Economic cycles and markets across the globe are highly dynamic, making it difficult to consistently time the winning asset class. However, a well-balanced mix of these asset classes can assist investors in achieving an optimum level of risk-adjusted return to reach their long-term financial goals.

For example, In FY12 and FY20, equity contributed negatively, but gold sparkled. However, regardless of these asset classes, fixed income provided stability to the portfolio.

In FY15 and FY17, equity performed well while gold corrected. Fixed income, on the other hand, remained isolated from the volatility of these assets.

Hence, a combination of these asset classes in a scientific way can be utilized to generate low-volatility returns.

Generally, it is a misnomer that, for the personal risk bucket, one has to keep capital protected and avoid taking risks. The definition of risk itself is not clear to most people because, as legendary investor Warren Buffett says, risk is the permanent loss of capital. Standard deviation of returns is not necessarily risk; in fact, it creates opportunities for returns. However, risk is defined as the permanent loss of capital, which is different from notional loss based on mark-to-market (MTM), etc.

If one is willing to move away from bonds and fixed deposits (FDs) and allow a judicious mix of asset classes that may exhibit volatility from time to time, but are uncorrelated or lowly correlated, and mixed in a specific proportion with rebalancing based on relative valuations, the chance for permanent loss is minimized. Although there may be occasional mark-to-market or notional losses, the overall return is enhanced by a few percentage points over time.

To improve the overall portfolio return, it is evident that shifting some allocation from the traditional personal risk bucket to strategies like multi-asset allocation can be beneficial. This shift should be done without altering the overall portfolio’s volatility too much.

Chirag Patel is co-head , products, WhiteOak Capital AMC.

Updated: 13 Jul 2023, 12:23 AM IST