The safety belt for your investment ride

A useful lesson in the current market is to remember that the smartest portfolio isn’t based on prediction. It’s based on planned diversification

The ground rules of investing are like the traffic rules in Delhi — more ignored than followed. Common errors include buying last year’s winners, no portfolio diversification, comparing equity returns to debt, and ignoring total portfolio returns. When the headlines begin to compare equity returns that look unflattering to a five-year bank deposit, we know that very few lessons have been learned — that the equivalent of driving on the wrong side of the road has become the norm in investing, not exception.

The only way to reduce risk is to have little bits of different assets so that they all do not go up and down at the same time. (Bloomberg)

Think of this article as a car that will leap past the traffic jams of bad investing decisions and keep you cruising safely with little need for either the clutch or the brake.

First, some maths. Let’s say you had ₹5 lakh invested five years ago. You put all of it in equity, in a Sensex Total Return Index (total return index includes dividends). An approximate average annual return of 4.6% over this period, would nudge your ₹5 lakh to about ₹6.26 lakh. A ₹5-lakh fixed deposit (FD) earning 6% annually, would have compounded to ₹6.69 lakh. I am not considering impact of tax here. The headline will scream: The cycle has overtaken the Tesla.

Why were you in 100% equity anyway? Because the stellar returns seen post-Covid made a 15-20% annual return seem like the norm. Not average, but annual. But markets react to geopolitics, the price of oil, or the mood of western oligarchs, and extrapolating three-year returns to eternity was most certainly an error. The average annual return over the past 15 years is around 11%.

But how are there investors who are still seeing double-digit returns? That story is always boring, needs discipline, and you need to forgo your bragging rights of how fast your car can go at social dos. It’s called asset allocation to build diversification. Let’s consider an alternative scenario: What if you had blended debt with equity? If you put ₹3 lakh in equity (4.6% return on the Sensex) and ₹2 lakh in debt (6% via FDs), you would have ended up with ₹6.4 lakh — right in the middle of a pure-equity or a pure-debt portfolio.

Now add two more ingredients to this mix: gold and a Nasdaq-100 exchange-traded fund (ETF). The distribution now is ₹1 lakh each in these, ₹2 lakh in equity and ₹1 lakh in debt. Gold and US markets did extremely well over this period with gold giving a five-year average annual return of around 24% and the US fund throwing up around 21% (after taking into account rupee depreciation) over the same five-year period. Your ₹5 lakh today will be worth around ₹9.4 lakh — giving you a healthy 13.4% average annual portfolio return.

But you needed to take this call at the start of the investing period and not jump into gold and then US markets mid-way. Nobody can always correctly predict what markets will do and which markets will perform. The only way to reduce risk and keep returns steady is to have little bits of different assets so that they all do not go up and down at the same time. This reduces what is called the overall portfolio risk. This insight, which mathematically formalised portfolio diversification, actually got Harry Markowitz the Economics Nobel in 1990. His modern portfolio theory (MPT) is a part of every class in finance; yet when the same people taking these classes build their personal portfolios, they drive on the wrong side and jump red lights.

Markowitz’s MPT (in a very simplified form) shows why it makes sense to spread money across different assets rather than put everything in one place. It does not guarantee returns, but makes the point that holding different assets together smoothens out wild swings. Indian equity, debt, gold, and US stocks behave differently, and it is impossible to predict even the direction over the next five years, let alone the return. When you combine such assets, this reduces risk for the same unit of return or increases return for the same unit of risk. The short point is you would have done better if you could predict markets and bought the winning asset five years ago, but since nobody can do that, blending different products leaves you better off than pouring all your money into just one asset.

What should you do? Even before you get to the specific to-dos, what you must do is manage expectations. If the map app shows that reaching the destination will take 56 minutes because of traffic jams, there is little you can do to reduce travel time to 30 minutes. The flying Tesla is not here yet. The biggest learning in investing is this: We can never get the best return because we cannot predict markets. The only way to navigate risky investments is to be happy with returns that keep your head above both inflation and tax. The only way to do that is to hold a diversified portfolio of assets.

Today — when there is overall gloom about markets — is the best time to do a reality-check on your portfolio. To all you 100% equity allocation people, I say this: Now is the time to build your debt buffer, specially if you are nearing or into yours 50s. Think of your portfolio as a pizza pie. Each slice is different and each product brings its unique flavour to the final experience. Debt products like FDs and debt funds will give you predictability, liquidity and safety. Gold gives a hedge against global uncertainty and inflation. Domestic equity gives you growth based on your own country. Foreign equity gives you geographical diversification.

Following the basic rules of investing will keep you calm and build distance from the sense of panic and upset that the daily cascade of financial advice and rhetoric induces. The goal is not getting there first at whatever cost, the goal is being belted-in safely to enjoy the ride.

Monika Halan is the best-selling author of the Let’s Talk series of books on money. The views expressed are personal