We have in the past discussed Liability-driven Investment (LDI) and its relevance to individual portfolios. LDI refers to portfolio construction process engineered to meet investors pre-defined future liabilities. This investment philosophy has been called to question by many who argue that investors do not always think in terms of their liability structure. We agree. Our aim through this column is to make them think as such. Why?
This article explains the issues related to typical investing process - Entrenched Investment. Specifically, it shows why such investing is sub-optimal within the risk-return matrix, making LDI a more optimal approach.
Entrenched investment
We define Entrenched Investment as the process of buying one security at a time, without concern to the overall portfolio structure. We call it - Entrenched - because the process is deep-rooted among investors.
An investor may buy, say, Reliance Industries, ONGC, HDFC and 25 other stocks one at a time, oblivious to how each stock reacts with the other. We are not saying that investors should always consider cross-correlations among securities.
Rather, we are concerned that separately evaluating each stock and constructing a portfolio as an after-thought could expose them to high risk.
Our point may be completely lost in uptrending markets when Entrenched Investment typically outperform broad market index. But it is important to understand that better performance does not necessary relate to skill. It could be simple case of the portfolio having high beta stocks - stocks with beta greater than one move faster than the broad market index. The problem is that they fall just as fast in a declining market! And that is not all.
Loss aversion effect
Entrenched investment has a large element of market timing. Now, successful market timers are the ones who employ appropriate risk management rules. It is moot whether mass-affluent investors following Entrenched Investment posses the required discipline.
Lack of discipline could lead to loss aversion. That is, lack of discipline could prompt investors to hold on to their loss-making positions for too long. This leads to opportunity cost and large realized losses when the security prices fail to rebound.
Suppose an investor buys a stock hoping that it will move up 25% in three months. Further suppose that the stock instead declines by 15% within one month. Investors adopting Entrenched Investment would typically hold the stock hoping that it would rebound in the next two months. It would be instead worthwhile to ask the question: Can the stock move by 47% in two months to reach its initial target return of 25%?
Goal-based investment
We believe having an investment objective helps the investor ask the right question. Suppose an investor creates a portfolio to buy a house five years hence. Such a portfolio construction process helps in several ways.
One, the investor has an investment horizon - five years in our example. Two, she knows the required portfolio value at the horizon - the amount needed to buy the house. And three, given the initial investment and estimated periodic contributions, she can also calculate the required return. In the portfolio management, this return is called the Minimum Acceptable Return (MAR)
An investment is considered risky if its return is lower than the MAR. A goal-based portfolio helps the investor take action when the asset values decline below the MAR. Importantly, MAR helps the investor is deciding the asset allocation strategy- how much to invest in various asset classes such as stocks, bonds, real estate and commodities. The asset allocation policy is important because it contributes substantially to portfolio returns.
Conclusion
Evaluating securities individually and investing for just returns may be profitable in the short-term, but lack of portfolio perspective will expose investors to higher downside risk over longer horizon. If nothing else, constructing portfolios based on investment objectives helps in better risk management.
No comments:
Post a Comment