Beyond averages: The case for smarter investing

We always look for certainty in any future outcomes whether it’s life or investments. But the world works on probabilities. Nothing is certain and that’s the inherent risk. When we begin to build this perspective, the outcomes are easily digested and we remain at peace. So, whenever we make an investment decision, while we assess the risk, we also assign a return to it. The better way to accommodate is to have a probability-based outcome.

For instance, if one is investing in stocks, the average one-year returns can’t be the expected outcome but the probability, say a particular percentage chances of generating a certain return. And we could drop down from the highest probability to the lowest with their corresponding possible returns. Similarly, replicate across various time frames. This could possibly provide for better return expectations.

So, when we’re bumped up with the question of where to allocate this fresh money, we tend to make our decisions usually based on the averages which is only one part of the story, but when we add the probability, it depicts the near-future results. Why is this important? Most investors don’t like their money to see a portion of their investment evaporate right after they invest. While this is a highly plausible scenario, we’re not wired for it and hence the reactions are extremes.

Even most of the claimed aggressive investors, tend to be tested by markets when they behave contrary to their expectations. Regret minimization is an essential strategy, though at times isn’t an optimal one, particularly during volatile markets. Of course, in the hindsight everyone is a genius but the best way to counter future in investing is only through rupee cost averaging for equities and diversification at the portfolio level.

In a diversified portfolio, the rules are established in advance of the actual investment. How much each asset class is allocated for and accordingly the dynamics of that asset’s implication accruing to the portfolio. When each of these allocations interact, we could arrive at a range of outcomes in terms of returns and yes, we could ascribe a probability to derive confidence.

For instance, data from the history shows that in the last 30 years, equity and gold in India remained limited correlated. Except for three years when both have delivered negative returns, the rest of the 27 times, either of them managed to give a positive return. That’s 10% of the time across three decades. It’s not an investment advice but a statistical analysis of these two asset classes during 1995 through 2024.

Diversification can happen within the asset class i.e., for instance in debt,with multiple types of instruments. While bonds are the most common sub-class, they vary across duration (tenure), coupon (interest) and risk (AA, B, etc. rating). Depending on the timelines and risk, the bond portfolio could have a mix of these bonds, so a better risk adjusted return is arrived. Again, these come with their own set of risks that include inflation/interest rate risk, liquidity- and default-risk.

Similarly, within equity there’re large-, mid- and small-cap stocks that have different risk and return profile. Each of these exposures could be varied depending on the goals and risk profile of the individual investor. With equity investments, the other way to reduce the risk is through rupee/dollar cost averaging. The popular SIP (Systematic Investment Plan) is another means of achieving this averaging in MF (mutual fund) investments. Likewise, this is also done in direct equity investments through SEP (Systematic Equity Plan) where either a fixed amount or a fixed number of shares are averaged for a pre-defined time to accumulate a large proportion of the same stock.

Of course, diversification is not just a one-time exercise and comes with rebalancing. This is something many investors forget and realize later that their portfolio doesn’t reflect their true self. The initial asset allocation is based on the goals, timelines and risk profile of the investor and as the investments grow, they could deviate from the original plan. For instance, an equal weighted portfolio of gold, debt and equity was planned initially and in a given year the returns from equity were extraordinary i.e., above the envisaged average the portfolio after a year will have an overweighted equity portion versus the planned. Though the portfolio value might be better than the anticipated, the risk associated with this portfolio mayn’t be suitable for the investor’s stated objective.

A mechanism to deal with those situations must be also premediated. Because as we oscillate between complacency and panic, inertia could set us from taking decisions. A rules-based rebalancing could help stick to the original intentions. For example, a 10% increase in any of the portfolio automatically shaved off and added to the other assets so that the original allocation is retained, etc. The other rebalancing could be periodic, as timelines move towards the goal, the portfolio adjusted. This is seen in Target Dated Maturity instruments where the allocation to riskier assets is reduced with time.

A successful investment process doesn’t mean to generate high returns alone, but it requires some limitations. It means one deliberately restricts certain behaviors, choices and impulses. Personally, I believe a good investment process should achieve the set goals within the defined constraintswithout the investor losing the sleep. For this, an investor should know themselves first and list down their priorities, inhibitions and biases.

The author is a partner with “Wealocity Analytics”, a SEBI registered Research Analyst firm and could be reached at info@wealocityanalytics.com