At a recent social gathering of investment professionals, a portfolio manager wanted to know why this column encourages people to seek investment solutions instead of trying to achieve returns higher than a market index (Nifty, for instance). This question is a telling sign of how portfolios are typically constructed - without clear investment objectives. As a follow-up to that debate, we ask the following question: When should investors `chase` higher returns?
This article discusses how individuals` construct layered sub-portfolios to meet their financial goals. It then explains the circumstances when individuals can `chase` higher returns within such sub-portfolios.
This article discusses how individuals` construct layered sub-portfolios to meet their financial goals. It then explains the circumstances when individuals can `chase` higher returns within such sub-portfolios.
Tiered portfolio
Individuals do not construct portfolios based on the correlations between various assets so as to reduce overall risk and optimize returns. They instead construct portfolios, hoping to achieve their financial goals.
Financial goals are typically three kinds. First, the lifestyle desires which include pre-retirement and post-retirement needs. Second, the intergenerational wealth transfer - how much assets should be given to the children. And third, the philanthropic needs - how much should be donated to charitable causes.
These multiple goals create complexity in the portfolio construction process; for the risk attitude towards each of these goals is different. The risk tolerance to lifestyle goals, for instance, is low compared with that of philanthropic goals. This means that the assets required to meet these three objectives differ substantially.
It is, hence, imperative that an individual has three sub-portfolios to meet these goals. Academic literature on portfolio construction suggests that such sub-portfolios may not be optimal. The reason is not far to seek.
Assets in each sub-portfolio may react adversely with those in other sub-portfolios to increase overall risk. Decline in government bond exposure in the lifestyle portfolio may, for instance, drag down returns in wealth transfer portfolio, if the correlation structure was not considered while building these sub-portfolios.
The positive side to having such sub-portfolios is that it acknowledges investor preferences and matches their financial desires with appropriate investment solutions.
Wealth mapping
Of the three sub-portfolios, lifestyle needs require the most conservative portfolio. The reason is because individuals need to sustain their basic standard of living and aspire for improvement in their quality of life. Investing is risky assets may expose the portfolio to high downside risk, jeopardizing basic living standards.
A conservative portfolio requires exposure to income-generating assets with low tolerance to downside risk. A major proportion of this portfolio would, hence, constitute fixed-income securities such as bonds and bank fixed-deposits, maturity-matched to the individual`s investment horizon.
The wealth transfer and philanthropic sub-portfolios will have some exposure to equity but not for `chasing returns`. These portfolios are instead custom-tailored to meet the desired financial goals.
So, can individuals `chase` returns at all? This is where one has to consider the importance of minimum desired portfolio level. Consider the wealth transfer portfolio. This portfolio is set up to generate wealth that can be tax-efficiently transferred to the next generation. Suppose an individual desires to leave Rs 100 million to her children but is determined that the intergenerational wealth transfer should not be less than Rs 60 million.
The wealth transfer sub-portfolio should be tightly structured to reduce shortfall risk on Rs 60 million. Beyond this threshold, the sub-portfolio can be structured to `chase` returns through exposure to alpha-generating strategies including market timing and security selection. The same principle applies to the philanthropic sub-portfolio and the aspiration component of the lifestyle portfolio.
These multiple goals create complexity in the portfolio construction process; for the risk attitude towards each of these goals is different. The risk tolerance to lifestyle goals, for instance, is low compared with that of philanthropic goals. This means that the assets required to meet these three objectives differ substantially.
It is, hence, imperative that an individual has three sub-portfolios to meet these goals. Academic literature on portfolio construction suggests that such sub-portfolios may not be optimal. The reason is not far to seek.
Assets in each sub-portfolio may react adversely with those in other sub-portfolios to increase overall risk. Decline in government bond exposure in the lifestyle portfolio may, for instance, drag down returns in wealth transfer portfolio, if the correlation structure was not considered while building these sub-portfolios.
The positive side to having such sub-portfolios is that it acknowledges investor preferences and matches their financial desires with appropriate investment solutions.
Wealth mapping
Of the three sub-portfolios, lifestyle needs require the most conservative portfolio. The reason is because individuals need to sustain their basic standard of living and aspire for improvement in their quality of life. Investing is risky assets may expose the portfolio to high downside risk, jeopardizing basic living standards.
A conservative portfolio requires exposure to income-generating assets with low tolerance to downside risk. A major proportion of this portfolio would, hence, constitute fixed-income securities such as bonds and bank fixed-deposits, maturity-matched to the individual`s investment horizon.
The wealth transfer and philanthropic sub-portfolios will have some exposure to equity but not for `chasing returns`. These portfolios are instead custom-tailored to meet the desired financial goals.
So, can individuals `chase` returns at all? This is where one has to consider the importance of minimum desired portfolio level. Consider the wealth transfer portfolio. This portfolio is set up to generate wealth that can be tax-efficiently transferred to the next generation. Suppose an individual desires to leave Rs 100 million to her children but is determined that the intergenerational wealth transfer should not be less than Rs 60 million.
The wealth transfer sub-portfolio should be tightly structured to reduce shortfall risk on Rs 60 million. Beyond this threshold, the sub-portfolio can be structured to `chase` returns through exposure to alpha-generating strategies including market timing and security selection. The same principle applies to the philanthropic sub-portfolio and the aspiration component of the lifestyle portfolio.
Conclusion
Chasing returns is clearly not an objective. Portfolios ought to be constructed to meet financial goals. Differing risk attitudes towards each goal prompts construction of several sub-portfolios. Investors can consider `chasing returns` within these sub-portfolios, but only after the asset exposure is custom-tailored to meet the minimum desired investment objectives.
Investors are often misled into believing that chasing higher returns is by itself an investment objective. This article shows why multiple financial goals create complexity and leads to construction of several sub-portfolios. It then explains when investors can `chase returns` within such sub-portfolios.
Investors are often misled into believing that chasing higher returns is by itself an investment objective. This article shows why multiple financial goals create complexity and leads to construction of several sub-portfolios. It then explains when investors can `chase returns` within such sub-portfolios.
No comments:
Post a Comment