Financial investments involve an element of risk. These risks tend to introduce uncertainty in portfolio values and impact return expectations.
By Vinay Ahuja
When you throw a stone in a shallow lake, you can cause large ripples and disturb its peace and tranquillity. However, when you throw a stone in a deep lake, you cause just a few ripples and barely disturb it. External shocks, like the COVID-19 pandemic and its consequent impact on economic activity, are stones that can cause ripples in your portfolio. They engender uncertainty and can lead to extreme market volatility. In the backdrop of such an environment, there will inevitably be ripples in your portfolio. However, the impact and extent of these ripples will be dictated by the depth and resilience of your portfolio.
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Financial investments involve an element of risk. These risks tend to introduce uncertainty in portfolio values and impact return expectations. This makes it imperative to build resilient portfolios that can ably navigate the changing investment climate and weather external shocks. As an investor, you can achieve this by identifying the true drivers of risk and return, while staying focused on your long-term objectives. To build resilient portfolios, you should be:
-Risk-aware: Risk is ubiquitous and can present itself in unexpected ways. The ongoing COVID-19 pandemic is testament to the fact that risk often catches us unawares. Thankfully, risk can be measured and mitigated. The first step is to be aware of potential sources of risk. Understand asset class risk and apprise yourself of the triggers that can increase uncertainty. The next step is to assess your own risk profile, which will reflect your willingness and ability to absorb risk. Risk mitigation is only possible when your investments are well-aligned with your risk profile.
-Diversification through astute asset allocation: This is probably the best way by which you can mitigate portfolio risk and build a resilient portfolio that can weather market volatility over the long-term. Diversification entails spreading your investments across multiple asset classes such that sharp movements in any one asset class do not have a disproportionately large impact on the overall risk-adjusted returns of the portfolio. Every asset class has a unique risk-return profile and responds differently to the same set of triggers. As a result, while certain events might lead to a sell-off in one asset class, they may have little or even the opposite impact on another asset class. In financial jargon, this means that different asset classes can have little or even negative correlation with each other. To achieve optimal diversification, you can adopt the asset allocation approach. As per this approach, you need to first determine your risk profile, return requirements, and investment time horizon. Based on these factors, you can allocate your investments across multiple asset classes such that the overall risk and return potential is well-aligned with your unique risk-return requirements.
-Agile: If your investment strategy remains fixed even while the investment environment and your needs are changing, then there is a possibility of breakdown. Due to the shifting nature of the investment landscape, it is important for you to be flexible enough to respond to changing imperatives and capture market opportunities. This means that you should be able to reduce exposure when markets are expensive, as defined by the P/E ratio and other valuation metrics, and increase exposure when the markets are cheap.
-Consistent and disciplined: Overall, you need to be disciplined and follow a consistent approach to portfolio building. Avoid getting swayed by market emotions or straying away from your asset allocation strategy.
Portfolio resilience is not simply about building a defensive strategy to combat current market volatility. A truly resilient portfolio will not only help you effectively mitigate short-term shocks, it will also ensure that you are able to navigate long term-trends to optimize risk-adjusted returns across market cycles.
(Vinay Ahuja is the Executive Director of IIIFL Wealth Management. Views expressed are the author’s own. Please consult your financial advisor before investing.)