My client was very happy with his portfolio returns. Over the last two years, he had made a cool 30% internal rate of return (IRR).
“We should invest more in equity, let’s get aggressive… Invest more in small cap funds as it had delivered the highest return,” he explained.
When we first met,he was a conservative first-time equity investor who had agreed toinvest a small part of his portfolio in equities only after a good deal of persuasion.This was only two years back, and the change in his perception of risk since then has been remarkable.
He is baffled that I used an 8% CAGR for calculating retirement corpus and thinks he will get there faster by being “aggressive”. He is not alone. The bull market is leading investors to believe that the returns from equities in the last few years will continue forever.An old advisor friend lamented that new investors have no idea about risk, while the old have forgotten what risk is.
Every new client’s portfolio contains red flags of excesses; if you see them in yours, you might need professional help.
Large collection of funds
New portfolios look like an assortmentof funds with overlapping holdings and no direction or strategy. Investors hold too many thematic, sectoral and smart beta funds and are clueless about risks and payoffs. Having multiple advisors/platforms and dozens of SIPs is routine.
Additionally, investors make tinyand irrelevant allocations to NFOs and ETFS. Irrelevant because the allocations are too small to impact portfolio returns significantly. Anything over five to six well-diversified mutual funds is excessive and needs pruning. More is not better in the case of mutual funds.
A portfolio skewed tosmall, mid-cap funds and themes
While small and midcap funds have done very well for investors, valuations in these are at historic highs. SIPs feeding into these segments have kept the price rise steady. However, in the eventof a black swan, highly overvalued segments can see brutaland long-term corrections. During the bull runbetween 2003 and 2007, the Indian economy was booming. There was this perception that nothing could ever go wrong with our markets. There was a frenzy in smaller companies, many of which went on to become multi-baggers. The mutual fund industry had alsojust launched small-cap category funds, and investors were lapping them up.
Franklin Templeton launched a five-year close-ended small cap fund in 2006 with much fanfare. Five years later, the fund opened, barely positive, and it was not before 2014 that it managed to hit a double-digit CAGR. That is, eight years to get to double-digit CAGR and mind you, Franklin’s small-cap fund was one of the better-managed ones.
Smaller AMCshad seen 50-60% erosion of NAV in smallcap funds. Small companies, themes and sectoral funds can also go through very long periods of consolidations and investors may not be prepared for such long time frames.
Also Read: How a strategically diversified portfolio can help you navigate market storms
Also, new investors haven’t seen deep corrections and permanent loss of capital which is routine in underlying investments of these funds. Not many will toleratea 20-30 % drawdown and stick with the investment for another five years.
Insignificant holding in debt, gold or cash
Advisors are having a tough time convincing investors to invest in non-equity assets. Debt, gold, and cash have an important role in balancing risks and also offer opportunities to invest when markets correct. Uncorrelated assets significantly contribute to overall returns by complementing growth assets. Equities are not the only asset class for building wealth, although that seems to be the popular narrative.
These red flags are always signs ofmisaligned return expectations. Expanding market valuations, the flood of IPOs , many of them of dubious quality, the surge in thematic NFOs and a booming bull market have led tounrealistic investor expectations of returns.
Average market returns historically have been in the range of 12-15%, and all market excess tends to correct and revert to the mean. Every rally without significant correction increases risks of sharper selloffs. If we don’t see the dreaded price correction, we might experience a time correction that runs into a few years and is equally damaging.
Investors will do well to prune their expectations of future returns at least in the short run. Bull markets are the best time to reassess, rebalance, align your portfolio to end goals and enjoy the sweet gains made. This may not be the time to get “aggressive”.
Kavitha Menon is a Sebi-registered investment advisor.
Also Read: Life cycle investing: How to adjust your asset allocation as you age.