Great time for a clean-up act

Use the ongoing bull market to your advantage and take a few corrective steps

Investors have seen buoyancy in returns over the last few years from both equity and bond markets. The VIX or volatility index in India, currently around 10, is now at all-time lows. Globally known as the fear index, a higher number implies increased volatility and a lower number indicates high complacency. Simply put, you get the best risk-adjusted opportunities when fear rules the street. In the recent past, small and mid-caps have compounded faster than large-caps with many stocks having frothy valuations and at substantial premiums to large-caps.

Some parts of the market look reckless with risk-adjusted returns completely out of favour. This is usually the phase wherein portfolio mistakes start to accelerate and hubris sets in. While most investors think of risk from a perspective of loss of capital or volatility, a few additional important factors like portfolio stagnation, illiquid positions and wrong product selection need to be considered. Market corrections are normal and eventually follow. How can investors correct their mistakes and use the current bull market window to their advantage?

Recency bias

Typically, investors tend to build up equity exposures when markets are rising rapidly as recency bias kicks in. Comfort increases with recent performance, ultimately leading to incorrect conclusions and incorrect decision-making. This is a good period to reassess your equity allocation and trim exposure if it is far higher than your risk appetite. An appropriate asset allocation is the best hedge against market volatilities.

Short-term fads

Be it realty, infrastructure, tech or media stocks in the past and NBFC stocks at present, market fads don’t tend to last beyond a few quarters. Sectoral exposure is risky and needs significant skill and timing to make outsized returns.

In most cases, it takes years for the sector to come back in favour and there will be a completely new set of players who will lead the charge. Therefore, cut out any dead wood as even opportunity losses will hurt.

Investors not used to accepting losses, end up holding on to investments with the hope that they can be sold once they break even. Not only will they continue to lose the time value, they also forego an opportunity to get into something better. Unless it is a good company undergoing a short-term difficult period, it is best to move on.

Diversification

Drawing a parallel to the word coined by legendary investor Peter Lynch, any investor who undertakes excessive diversification ends up getting sub-optimal returns. While a concentrated portfolio comes up with its fair share of risks, too many investments with similar strategy will not achieve the objective of negative correlation. The rising tide of the market has carried everyone along; this is a great time to consolidate.

Illiquid positions

One of the biggest portfolio risks would be illiquid investments. Close-ended mutual funds, private equity or real estate funds usually end up forming a large part of the risky assets. These exposures not only restrict the ability to generate liquidity, any underperformance has to be tolerated as there are no exit windows. To boot, there are no additional returns or tax efficiencies for undertaking this risk. Now is when you need to be wary.

Chasing yields

Unlike equity, any loss of capital in debt is permanent. In their endeavour to ‘improve’ yields, investors have been investing at the lower end of the credit quality curve.

Real-estate funds, credit mutual funds, mezzanine fund, AIFs investing in balance-sheets of stressed companies have all mopped up large monies with clients, blissfully unaware of the risks. Any aggressive exposure to risky debt would be counter-productive. Head to the exit door when the music is still playing.

While the current markets are a great time to get into the clean-up act, it is equally important to ensure that no significant risks are taken.

Investing in uncomplicated products with transparency and having sufficient clarity on the investment outcomes is paramount. Investors realising their mistakes and correcting them have a significantly higher chance of meeting their investment goals.

The writer is is co-founder and Director at Entrust Family Office Investment Advisors

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