We build investment portfolios to help us reach our goals. The aim is to optimize returns and manage risk and to this end we diversify and rebalance this portfolio. Here are a few situations when our portfolios may send warning signals, for us to take corrective action.
Returns are too high
When the returns earned from a portfolio are much higher than expected, it may be a cue to check if all is well with the portfolio. The most significant reason may be that the asset allocation has shifted towards higher-earning but riskier asset classes like equity. This may mean that the portfolio is not synchronized to your needs. This can happen if you don’t track and rebalance your portfolio periodically, to ensure it is suitable to your needs. For example, a run-up in the value of an asset class with higher returns, such as equity, will make it a larger proportion of your portfolio if profits are not booked and the proportion of equity in the portfolio rationalized periodically.
Your asset allocation could also get skewed if your debt holdings have matured and the proceeds have not been re-invested in that asset class. Instead you may have increased holding in equity in anticipation of better performance. Or, interest income earned on debt holding may have been invested in equity or other higher-return products. A larger portion of the portfolio may now be in investments with volatile values and limited liquidity. This may make it difficult to redeem investments when goals have to be met. Or, you may even have to redeem at a loss.
If investment values going up without a sound economic reason, it is also a signal to watch out for correction in the asset class. It may be fueled by excess liquidity or unfounded enthusiasm. It is a good move to rebalance the portfolio at this stage instead of waiting for the cycle to peak.
Too much risk
Are returns from your investments fluctuating significantly? Is there a delay, or default, in receiving income from investments that you are contractually entitled to receive? Do you see the value of your investments declining, and is it difficult to exit them? These are signs that the investment has turned risky and it’s a signal to investigate into the reasons for this behaviour. Unless there is a satisfactory explanation, consider switching instead of waiting for the conditions to recover. You can pick these signals from your annual portfolio review and then put some investments on watch with frequent evaluations, and exit them if needed.
Too much diversification
Do you have difficulty listing all the investments you hold? Do you find that a rise in value of investments is not translating into gains for your portfolio? If that is so, chances are that you are over-diversified. A diversified portfolio is an efficient way to manage the risk in a portfolio. But you need to watchout for over-diversification. When you invest in all products that come your way, and spread your money thin over many investments—you may be taking diversification too far. Your portfolio should have enough exposure to an investment, if gains from it are to reflect in your portfolio. Similarly, you should track individual parts of your portfolio to ensure you are not duplicating your investments without any benefits of diversification. Too many investments can also limit how well you can monitor them. Holding a large portfolio implies higher costs of acquisition and maintenance. When diversification starts to impinge on your returns, it is a signal to rationalize the portfolio so that is not needlessly condemned to lower returns.
Too much safety
Do you find that your savings and investments don’t seem to bring you any closer to your goals? This may be because you may have played it too safe while investing your savings. If your money is primarily held in cash and shorter-term debt products with low interest rates, your corpus would be denied the benefits of compounding. Also, the real value of your savings will erode over time due to inflation. All this because your portfolio did not reflect your ability to take risk. A better way of looking at safety, which will protect your financial situation, would be to allocate your savings to investments that reflect the needs of your goals for growth, income or liquidity—and linking the investment horizon of each goal to the investments made for it.
Too much monitoring
If you think your investments need to be tracked daily, to update their current values and calculate losses and gains, then you may be doing yourself a disservice. For one, it becomes difficult to stay the course when you frequently see a fall in values. You may be prompted to sell without evaluating whether the fall reflects a depreciation in the intrinsic value of the investment. For example, you may be tempted to increase allocation to equity when markets are going up, making your portfolio riskier than it should be. Or you may be spooked into exiting riskier asset classes when you see values fluctuating or falling—and miss out on a rally. These actions would affect your long-term goals as they would make the portfolio drift away from what is dictated by your needs. Frequent actions on the portfolio have costs and tax implications that eat into the returns. If you start with a well-balanced portfolio, then a quarterly monitoring with an annual rebalancing schedule should be adequate, unless there is a change in needs or circumstances.
Too much liquidity
Does your savings bank account show a healthy and growing balance? This may not really be a healthy situation for your financial situation. Liquidity that is linked to a specific purpose or goal is a good thing. For example, holding funds to meet emergencies is a positive increase in liquidity.
However, excess liquidity is a sign of under-using your savings. Your money is better-off being invested so that it works for your goals rather than sitting idle. You may be missing opportunities to earn returns if you are not invested when markets see a rally. Apart from missed opportunities, excess liquidity can lead to impulsive spending or investing. Both are bad. You may be choosing investments for the wrong reasons, such as the hype surrounding it and a run-up in its values. If an investments is not aligned to the prescribed allocation for your portfolio, it may do more harm than good.
These risks to the portfolio may be managed to a great extent by putting a few simple portfolio checks and balances in place. Start with an asset allocation that meets the needs of your financial goals. Have a monitoring and rebalancing schedule in place and the discipline to stay with it. Let your investment decisions be dictated by your goals rather than market movements.
First Published: Tue, Jul 25 2017. 04 36 PM IST