Here are a few perfectly relevant and ‘good’ questions in personal finance or money management with arbitrary answers! In my opinion, the following questions are distinctly different from those that seek the best insurance or investment products to buy. There are right questions to ask, the answer cannot be based on a formula.
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How long should I wait for my active fund to beat the market?
Suppose you are holding a large-cap or small/mid-cap fund? The respective fund manager is expected to “beat the market” (respective benchmarks) to put it crudely. Does beating the market mean more returns, or less risk or both? Debatable! For the case of simplicity, let us assume that it means more returns.
Now, how long should I wait for my actively managed fund to beat the market?
I have usually maintained that I would prefer to give it at least 3 years or even a bit more. But this is an arbitrary answer. There are those who say, if the performance dips for a few quarters, exit. Then are others who want to quit if the fund drops a star.
Nothing wrong with the question. It is a right one and a good one. However, open-minded people will realise that the answers are arbitrary. I guess that as long as we do not end up cluttering the portfolio (unable to justify fund positioning to ourselves) and do not pay much of tax and exit load, it should be okay.
I have held on to temporary underperformers for years together. Only to see them spring up within weeks. That is the nature of the market.
I have also been subjected to the investor’s curse: My fund (A) underperforms compared to another fund (B). I stop investing in A and start investing in B. A little while later, A edges past B!
Patience plus objective reviewing helps, but the answer is still arbitrary per se!
How do I handle a 2008-like situation?
Again a very good question that everyone should ask. Answers are not easy. A crash when viewed in hindsight, is very different from a crash in real-time. We often would not or cannot realise what is happening.
In hindsight, it appears as if the crash occurred because the index PE was high. However did the US housing bubble burst because our index PE is high? Crashes are triggered by specific events and that does not include a high PE!
If the answer to ‘how to handle a crash’ is to quit and stop loss, then we might be exiting at the drop of a hat. In real time, what looks like a future decline can quickly change over a few days.
My point is, formulaic answers are not possible. We will have to recognise that risk management is
1 contextual Sometimes a spike in market volatility (measured by India VIX: The Stock Market Volatility Index) matters. Sometimes market valuations as indicated by the health of one’s portfolio matters. One can contain losses by being systematic: Simple Steps to De-risk Your Investment Portfolio
In addition to regular rebalancing, one can also rebalance the portfolio each time the market is at an all time high or rebalance just before Lok sabha elections (uncertainty can increase the VIX index) etc. This is for managing losses and not preventing them.
2 dynamic Portfolio management involves playing it by the ear. That is we will have to react to specific market movements. Sometimes, the reaction can be – no action and sometimes, book profits or invest more. Such actions depend on your requirements, which are dynamic too.
The answer to this question is arbitrary if you ask someone else! A personalised solution (which is also dynamic) will work as long as we do not worry about whether it the ‘best’ or not! If the aim of asking the question is to prevent losses then it is a wrong question!
How much mid-cap and small-cap stocks should I have in my portfolio?
There are some amusing answers to this based on past performance. Somehow I think such question arise from a fear of being left out. I hold a portfolio with a large cap tilt and I see 40% return from DSP Microcap in the past year and want to increase exposure to that. Then I hear someone say that large caps will underperform other categories in the “long run” and think my portfolio construction is all wrong.
The main problem is that many of us think that we can withstand market ups and downs and things will turn out okay in the end. As mentioned above, market shocks are dynamic. Each crash we have witnessed so far has been unique and I think that pattern is likely to continue.
The problem with mid and small cap stocks is the volatility. They can deliver great returns for a couple of years and then offer nothing for the next few. The argument that “my goal is far away, and I can wait” is a little too simplistic. Returns from a particular asset subset depend on when we choose to look!
I can come up an ideal asset allocation among large, mid, small and micro-cap stocks based on past performance. What good would that do?
I can also repeat this exercise in real time and find out the desired asset allocation once a month, once a quarter etc. The question is, how many of us are interested in such level of analysis and does such number crunching help in the first place?
Whatever we do, the answer to this question is arbitrary per se. Nothing wrong with the question as long as the objective is not to obtain “best returns”.
Assuming we stay invested, our ability to handle risk changes with time. We can always gradually take on more volatility by increasing mid/small cap allocation after we get comfortable.
The central point of the post: many aspects of money management involves taking things as they come. We must know how to identify and manage risk, but what we actually do depends on the situation. That sounds a bit scary, does it not!