Why downside protection matters and some basic maths:
Take a look at the two portfolios. If you invested 1 crore, which portfolio would you want?
The arithmetic average of portfolio A is 23.75% and B is 18%. You might be tempted to think that despite the somewhat volatile nature of returns from A, that’s the one which gave higher returns over the past four years.
However, that’s not true at all - a simple average would give you an absolute wrong answer in returns calculations. This is because investment returns are multiplicative in nature, not additive. Lets see what how your 1 crore grows over a period of four years in both the portfolios:
So although Portfolio A appears more exciting, and can generate some “cool” stories to tell your friends, its total value at the end of Year 4 is less than Portfolio B.
This is why consistency matters.
This is why downside protection matters.
This is why having a boring investment is not a bad idea at all.
Especially if you are an ultra high net worth individual, protection of portfolio should precede in importance, compared to high returns from the portfolio.
Making +90% return on your portfolio, over a period of 4.6 years at 15%, might seem like a boring return. But if you lose 90% of your money in the first year and come to 10 from 100, you would take many years just to try and break even.
A 10% loss requires a 11% gain to get back to break even
A 20% loss requires a 25% gain to get back to break even
A 50% loss requires a 100% gain to get back to break even
A 90% loss requires a 900% gain to get back to break even
This lesson should be kept in mind while chasing the latest fads such as buying hot stocks, sectoral funds, funds with particular market cap criteria (small caps), structured/leveraged products, start up funds, IPO funds, etc.
Investing over the long run is like running a marathon, not a sprint. You must bet on the most consistent runner, not the fastest one.
Surprising revelations, returns from different categories over the long run:
This chart shows the average returns from fund categories over different periods of time. An interesting thing to observe is that over a 5/10 year period, large/mid/small/growth/value – all gave similar returns.
In theory and in most periods, large caps are less volatile in nature compared to small and mid caps. And if in the longer run all categories give similar returns, why chase riskier assets excessively?
I am not saying that you should skip mid or small caps funds entirely, but just limit their exposure in your portfolio. There are periods when mid and small caps outperform large caps and vice versa. To achieve better portfolio diversification across cycles, an investor portfolio should have an appropriate mix of both large caps and mid/small caps.
Since returns of large cap and mid / small cap should not diverge materially over the medium to long term, in my opinion, a 70% allocation to large caps and 30% allocation to mid and small caps is a sound strategy for a typical investor.
Investing is simple, but not easy. This is said because from time to time you might be tempted to deviate from the traditional plan and invest in a new concept or idea that you are so sure about (obviously this is more of a gut feeling, not a thoroughly studied investment idea), or something your friends made money off or in a product excessively pitched to you by a banker or wealth management intermediary.
Since your behavioural biases will not allow you to say no to all of these ideas, build a rule for yourself. It can be something as simple as, you will not invest more than 30% of your equity asset allocation in a high risk asset.
So your overall equity portfolio should look something like this:
Part I. Structural Core Portfolio (70%)
Part II. Tactical Portfolio (30%)
Other Crazy Stuff
Following an asset allocation, setting basic controls on your portfolio, realising that boring investments can indeed help you grow your wealth over the long term, and protect your portfolio from major drawdowns, can make a huge difference in your wealth creation story.
Hence investing with a boring but consistent fund manager might not be such a bad idea after all.
Downside protection is more important than extremely high returns.
Have the majority (roughly 70%) of your investments in large and multi cap funds.
Set maximum percentage limits on yourself if/when investing in extremely high risk bets.
“Investing should be more like watching paint dry or watching grass grow. If you want excitement, go to Las Vegas.” - Paul Samuelson