Pointers For A Pragmatic Review

Reviewing our portfolios regularly is key to effective money management. This is even more true when following a goal based approach to investing. Most investors focus on returns and performance when conducting a review. But there is a lot more required to make a review effective. Therefore today I will talk about the principles that govern an effective portfolio review. These principles are given assuming that the investor has followed a goal based approach to money management. The periodicity of the reviews is assumed to be annual.

Relevance Over Performance

An effective portfolio review begins with answering the following questions :

1. What are my goals at this point of time?

2. How have they changed (if at all) in comparison to last year?

3. Is the asset allocation of the portfolio for this goal in line with the remaining tenure of the goal?

4. Are the products in the portfolio for this goal relevant to the requirements of the goal?

The answers to these questions would offer practical insights on the effectiveness of our portfolios. This is especially true for the last two questions given above. Performance becomes irrelevant if our asset allocation or product choices are not in line with our goals. Getting both of them right is hence much more important than evaluating return figures. Only when both of these are in place does it make sense to evaluate returns.

Ruthless Rebalancing

I have answered the question of how to rebalance in an earlier article Restoring Equilibrium. Therefore I will not be covering that aspect here. But the fact remains that most investors are extremely averse to rebalancing. We ask the following questions when the need to rebalance arises :

1. Will rebalancing create long term tax implications for me?

2. Can I adjust the amount of my periodic investments in the future instead of rebalancing?

Rebalancing only implies a slight reduction in exposure to an asset class we are overly exposed to. Also tax implications from rebalancing only arise in the year where rebalancing is effected. Managing exposure by adjusting our upcoming investments is dangerous. Firstly it would take a number of years to bring actual allocations on track by doing this. Also if there is a market crash in the interim, the entire portfolio would go for a toss. There is hence no point in doing either of these things.

But the actual issue here is much more pervasive. These questions do not represent genuine doubts that we have. They are nothing more than an attempt to rationalise our aversion towards rebalancing. Our money management would never be effective until we overcome this aversion. We also defer rebalancing under the pretext of making the most of a bull run. This shows that we do not understand the reason why rebalancing is essential.

Rebalancing does not boost returns. It only smoothens our journey by reducing volatility and the impact of drawdowns. We must remember that our investment journeys happen in real time. Returns are realised only in hindsight. The smoother our investment journey, the better our chances of achieving desired outcomes. The Vanguard Advisor Alpha report shows that regular rebalancing can add upto 0.12% per annum to long term returns. This is borne out in the graphic below. It tracks the performance of a 60-40 stock-bond portfolio with and without rebalancing over a 60 year horizon between 1960 and 2025.

Notice that the blue line is higher and less volatile than the yellow one. This implies that rebalancing improves returns through risk reduction as implied earlier. Rebalancing involves taking money out of asset classes which have done well. The money so removed is then put into an asset class which has remained relatively more stable. Most investors would not have the maturity or conviction to do this.

They delay rebalancing to try and squeeze every last bit of profit out of an asset class. This often sees them wait too long. By such time the well performing asset class would have crashed. And the opportunity would then be lost. We must therefore learn to do the needful right when it needs to be done. We must rebalance the moment we find that allocations have crossed our preset threshold limits. This requires us to display conviction and ruthlessness in equal measure. I have answered the questions of when to rebalance and how to rebalance in an earlier article Restoring Equilibrium.

Risk Awareness Over Return Awareness

Most of us choose to invest in a particular asset class because of the expected return the asset class offers. But very few of us (if any) make the prior effort to also understand the risks involved with that asset class. Evaluating risk before entering an asset class or product gives us a well rounded perspective on it. Let me explain this with an example.

Gold as an asset class has delivered returns in the region of 65-70% over the past few months. Naturally, investor interest in gold is very high in this moment. Those who invest in gold at this point would be displaying return awareness. But the risks involved are being ignored. Mature investors would analyse the prospect of investing in gold as laid out below.

Gold has definitely done well recently. But history shows that gold is a volatile asset class. Periods of supernormal returns don't come often or last long. The current phase of outperformance is unlikely to last much longer. It may be better to stay away from gold at this point of time. I will not put more than 5% of my portfolio in gold even if I do participate.

This is exactly what risk awareness is. It is the humility to accept that things can go wrong. It is the foresight to identify how things can go wrong. It is the discipline to have pragmatic plans in place for the eventuality where things do go wrong. Risk awareness does not always have to mean not participating in an opportunity. It just means participating in opportunities as responsibly as possible. Therefore decisions to include or remove asset classes and/or products should come from an awareness of risk rather than returns. This reduces the probability of us second guessing our product choices and investment decisions.

Corpus Growth Over Returns And Strategy

There are two standard parameters used to assess the effectiveness of an investment portfolio. These are portfolio returns and the investment strategy employed. But from a practical standpoint both of these are not very relevant. The ultimate objective of planning finances is to ensure that we have enough money for our goals when they fall due. Therefore it the actual value of the portfolio that matters more than the rate of return. The most realistic way to evaluate the performance of our portfolios would therefore be to track their values over time. When evaluating the portfolio for a goal, the key questions to ask ourselves are as follows :

1. How much money do I need for this goal?

2. What is the Current Market Value (CMV) of the portfolio built for the goal?

3. Does the CMV of the portfolio leave me with enough money to meet the goal?

4. If not, what is the value of the gap that needs to be provided for?

5. What is the value of the annual and monthly investment required to fill the gap?

These questions can be incorporated into a simple calculation as shown in the graphic that follows.

The key inputs here include the current cost of the goal, CMV of the portfolio and the years to goal. The key outputs are the annual and monthly investment amounts required. This calculation can be carried out once a year. Updated values may be taken for the key inputs each year. This allows us to account for :

1. Inflation in the cost of the goal

2. Growth in the market value of the portfolio meant for the goal.

3. Changes in the investment horizon of the goal.

The key inferences that can be drawn from this calculation include the following :

1. If the value of the gap to be funded = 0, it means we have enough money for the goal. No further investments would be required for the goal in the current year. The adequacy of the amount available would need to be reviewed annually until the goal falls due. Additional investments may be required for the goal during future years on the basis of the annual reviews.

2. If the value of the gap is greater than zero, we must look at the required monthly investment amount. If this amount is within our monthly saving capacity, it means that we are on track to achieve the goal. It also shows that our portfolio is growing adequately. And if such is the case, the rate of return from the portfolio is irrelevant.

If the required amount is more than our saving capacity, it means we need to invest more for the goal. It may also imply that our portfolio has not grown as expected during the current year. The additional amount of savings required may be generated by increasing income or reducing expenses. This reduces our dependence on returns from the portfolio.

The method described above is based on the concept of Zero Real Returns. It represents a much more realistic way to evaluate the performance of our portfolios. Performance evaluation would happen in real time on the basis of actual figures. The need to make assumptions about inflation and rates of return from the portfolio is negated.

Closing Thoughts

A portfolio review is mostly seen as an outward looking exercise aimed at evaluation and comparison. But it is actually an exercise aimed at introspection. An effective portfolio review should be able to tell us :

1. Whether we are investing enough for our goals

2. What our allocations to various asset classes in our portfolio look like

3. Whether we are comfortable with these allocations (through introspection)

4. Whether our portfolios are growing adequately to facilitate timely achievement of our goals

As long as these questions are answered, superficial metrics such as returns and choice of investment strategy do not matter as much.