In a world that increasingly seeks “instant” product and service delivery, 2021 proved to be a year of “get-rich-instantly” through stock markets too. However, it is essential not to extrapolate the last year’s trend going forward. While markets are likely to tread higher in the medium to long term, the first half of 2022 is likely to be a bit topsy turvy for investors, as indicated by the recent plunge of the Indian stock markets. So, how should you make the new year count with your money growing while you sleep?
Before we get around to an answer, we must brush up on some basics. On a very elementary level, we buy stocks of companies where we feel the management understands the nuances of running their business and can efficiently grow their capital at a much higher rate than the risk-free rate of return (government bond rate). If they can do this consistently, year after year, the company’s value shall grow too. As a shareholder, you tend to benefit from the rise in prices of the shares from the company you own. The companies that have done this consistently in the past invariably attract more investor interest, therefore, never available cheap. On the contrary, poor capital allocators lose value over time. As a long-term investor, it is essential that you are invested in businesses that can compound their profits at a much higher rate than the risk-free rate of return consistently (for ease of understanding, let’s consider the rate as the prevailing FD rate). How?
1) Play The Long Game: Choose Equity Mutual funds for the long term
Historically, Equity Mutual funds have proven to be very efficient compounders of wealth over the last two decades. Fund managers and their teams keep filtering companies based on their efficiency in incremental capital allocation and generating a higher return on incremental capital. Imagine a company that, on a 100 Cr capital, generates 20 Cr profit and returns it entirely to the shareholders as a dividend (forget the tax for the moment). Would the value of the firm grow? The answer is a resounding NO. Now compare this with a company that deploys the 20 Cr profit back into the business and generates 50 Cr profit next year. Thus, it keeps growing the incremental profit more than the risk-free rate of return year after year. So, in order to reduce risk and volatility, beginners can start with Flexi cap funds that are open-ended dynamic equity schemes and can help investors broaden their horizons by investing in firms with varying market capitalizations.
2) Prosperity in Diversity: Diversify your assets
Even though a cliche but a proven one, diversification helps in the medium term. Investments and asset allocations are rarely made to be kept forever; in most cases, money is invested and taken out from portfolios at various points in time whilst providing for various milestones in life. If the portfolio is diversified across asset classes that are diversely correlated, the impact on your portfolio during large market drops is limited.
Imagine portfolio A, which is exactly correlated to Nifty. On a 20% drop in Nifty, the principal investment of 100 will drop to 80. For it to come back to 100, it needs to grow by 25%. Whereas portfolio B, which has a 70% correlation to Nifty, drops to 86 and needs to grow by 17% to return to the same level. Also, if you are invested in diversely correlated assets, other inversely correlated assets add incremental returns to your portfolio during equity declines. E.g., research suggests that REITs in the short to medium term have a very low correlation to equities, whereas, during large market corrections, REITs have a similar correlation to equities.
If managed well, a balanced portfolio of equities, fixed income, REITs and commodities would ideally take a much lower risk to generate around the same return as equities in a 10-year cycle. Thereby giving lesser shocks during large market falls. Ideally, a diversified portfolio should comprise domestic (Indian) equities, developed & emerging market equities, REIT, commodities & fixed income in measured proportions. Multi-asset funds are a good start for beginners.
3) Asset Allocation 101
While quite like the previous point of not keeping all your eggs in one basket, you can choose to either go with constant asset allocation or dynamic asset allocation in your portfolio. Unlike constant asset allocation, where you rebalance the assets in the same proportions after regular intervals, in dynamic asset allocation, you decide to go higher or lower in the constituents of your portfolio based on certain pre-defined parameters like valuations, market momentum etc. Such a strategy helps you book your profits regularly from overvalued assets to reinvest into lower volatility assets and vice versa. Also, in certain extreme scenarios, this strategy gives the flexibility to go much higher in the most undervalued assets in your portfolio. Balanced Advantage funds have done this job very efficiently for over a decade and offer a good starting point for beginners.
4) Relax, Rome was not built in a day
Once you have done all the above, just relax and stop looking at your portfolio daily. Investing is like planting a tree. You need to give it enough time to grow from a sapling to a tree. But, on the other hand, do make sure that you review it every 6 months for any excesses and deficiencies.
Views expressed in this article are the personal opinion of Vishal Vij, Founder & Chief Executive Officer, Nestegg Wealth.