My client was very pleased with the performance of his portfolio. Over the past two years, he had earned an internal rate of return (IRR) of 30%.
“We should invest more in stocks, let’s be aggressive… Let’s invest more in small-cap funds as they have delivered the highest returns,” he explained.
When we met, he was a conservative first-time stock investor who had agreed to invest a small portion of his portfolio in stocks only after much persuasion. That was only two years ago, and since then the change in his perception of risk has been remarkable.
He’s puzzled that I used an 8% compound annual growth rate (CAGR) to calculate retirement capital, and he thinks he’ll get there faster if he’s “aggressive.” He’s not alone. The bull market is leading investors to believe that the stock returns of the past few years will continue forever. An old advisor friend lamented that new investors have no idea about risk, while old ones have forgotten what risk is.
Every new client’s portfolio contains warning signs of excess; if you see them in yours, you may need professional help.
Large collection of backgrounds
New portfolios look like a hodgepodge of funds with overlapping positions and no direction or strategy. Investors have too many thematic, sectoral and smart beta funds and have no idea about the risks and rewards. Having multiple advisors/platforms and dozens of SIPs is a common occurrence.
Furthermore, investors make minuscule and irrelevant allocations to NFOs and ETFs. Irrelevant because the allocations are too small to significantly impact portfolio returns. Any allocations greater than five or six well-diversified mutual funds is excessive and needs pruning. More is not better in the case of mutual funds.
A portfolio focused on small and mid-cap funds and themes
While small and mid-cap funds have performed very well for investors, valuations for these are at all-time highs. SIPs feeding these segments have kept the price rise stable. However, in case of a black swan event, the highly overvalued segments may see brutal and long-term corrections. During the bull run between 2003 and 2007, the Indian economy was booming. There was a perception that nothing could go wrong in our markets. There was a frenzy in smaller companies, many of which ended up becoming multibaggers. The mutual fund industry had also just launched small-cap category funds and investors were snapping them up.
In 2006, Franklin Templeton launched a five-year closed-end small-cap fund to great fanfare. Five years later, the fund opened, barely making any money, and it wasn’t until 2014 that it managed to achieve a double-digit CAGR. That is, it took eight years to achieve a double-digit CAGR, and mind you, Franklin’s small-cap fund was one of the best-managed.
Smaller AMCs have seen 50-60% erosion of NAV in small-cap funds. Smaller companies, thematic and sector funds can also go through very long periods of consolidation and investors may not be prepared for such long time frames.
Read also: How a strategically diversified portfolio can help you navigate market storms
Moreover, new investors have not experienced deep corrections or permanent capital losses, which is common with the underlying investments of these funds. Not many will tolerate a 20-30% drawdown and hold on to the investment for another five years.
Negligible holdings of debt, gold or cash
Advisors are having a hard time convincing investors to invest in non-equity assets. Debt, gold and cash play an important role in balancing risks and also offer investment opportunities when markets correct. Non-correlated assets contribute significantly to overall returns by complementing growth assets. Equities are not the only asset class for wealth creation, although that seems to be the popular narrative.
These warning signs are always indicative of misaligned profitability expectations. Expanding market valuations, a flood of IPOs, many of them of dubious quality, the rise of thematic NFOs and a booming bull market have led to unrealistic profitability expectations on the part of investors.
Historically, average market returns have been in the 12-15% range, and all market excesses tend to correct and revert to the mean. Every rally without a significant correction increases the risks of steeper sell-offs. If we do not see the dreaded price correction, we could experience a temporary correction lasting several years and being equally damaging.
Investors should lower their expectations of future returns, at least in the short term. Bull markets are the best time to re-evaluate, rebalance, align your portfolio to your ultimate goals and enjoy the good gains you have made. It may not be the time to get “aggressive.”
Kavitha Menon is a Sebi registered investment advisor.
Read also: Life-Cycle Investing: How to Adjust Your Asset Allocation as You Age
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