A successful investment is a by-product of discipline, and diversifying risks
People have many options to travel these days. Starting from walking and cycling to personal and public transport like two-wheelers, cars, buses, trains, airplanes, etc. At times, if the distance is less, we may choose to walk over a car to avoid traffic jams. Similarly, our choice of financial investments depends on multiple factors – like our goals, time horizons, valuations of various asset classes, understanding of risks, and more important response to those risks when they materialise.
However, one can remain focused on their pursuit of financial goals and the compounding of wealth. A good starting point is putting certain factors into two buckets – controllable factors (like defining your goals, horizons, resources that you can spend to understand various asset classes, your behaviour) and external uncontrollable factors (like valuation, various events like elections, wars, trade uncertainties, etc). Once we have a better understanding, we can attempt a framework as to what investment avenue among the myriad choices is more likely to match with our expectations.
Broadly, for longer-term goals (think in decades), equity as an asset class has a high probability to compound wealth and give inflation-adjusted real returns. Within this broad asset class of equities, there are options of multi-asset, hybrid, or balanced advantaged funds and pure equity funds. Similar to the vehicle example, each of these factor present options of trade-offs. If you are confident of your perception of risk, the volatility of markets, and the long-term horizon, then pure equity funds are for you. You will still have to evaluate the uncontrollable factors, but the onus of timing broadly resides with you.
However, for many who are new to markets, and get overwhelmed by multiple factors and varying asset classes – avenues like multi-asset or hybrid/balanced advantaged funds may be more suitable. These funds focus on having an all-season vehicle for compounding one’s wealth. So, what are the trade-offs? They are unlikely to be nimble like pure equity funds, which when the going is great, can lead to faster wealth creation in a short time (think of a high-speed car on a national highway), as some portion of the fund will reside in lower volatility assets like debt or other assets like international equities or gold. So why should an investor consider these funds? Because there is only one free lunch in financial markets, and that is diversification!
Simply put – diversification is a financial term for the proverb – ‘Don’t put all your eggs in one basket.’ Diversification works when uncorrelated assets are combined – i.e. assets which are swayed by different factors like gold, bonds, equities, currencies, etc. While there may be some phases where they all seem to move in tandem, generally over longer periods, they move differently. So, when equities perform, maybe an asset like gold takes a breather, and while bonds move, maybe equities take a breather, and so on. Multi-asset and hybrid/balanced advantage funds work by utilizing this principle of diversification. However, just blindly putting a static portion to each asset class may not be optimal. So, there are specific models that most balanced advantage funds or multi-asset funds employ, and this provides a better experience to the investor at far lower volatility. Just like an automatic car changes gears, these funds help automatically change allocations to the varying asset classes.
At the end of the day, successful investment is a by-product of discipline and diversifying risks of uncontrollable factors using a well-defined process. If one can master this framework, one can have a focused portfolio with a far more pleasing experience.
Good luck in the investing journey.
The author is Executive Vice-President & Fund Manager Equity, Kotak Mahindra Asset Management Company
DISCLAIMER: Views expressed are the author's own. Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.