Good, Bad And Ugly Portfolios

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Good, Bad And Ugly Portfolios
Good, Bad And Ugly Portfolios
Nilanjan Dey - 05 February 2022

Portfolios are somewhat like spaghetti westerns. You can view them any number of times, and each time you do, there will be a new learning or two. And what could serve as a better example than the eminently watchable The Good, The Bad And The Ugly, the Clint Eastwood classic that weaves itself around a terrific plot and, as most fans will vouch, a quiver of catchy one-liners?

I will stretch my imagination a bit and leverage the film’s title to divide portfolios into three categories—good, bad and ugly—each with its own features, each defined by distinctive characteristics. Their differences are reflected in the dissimilar returns they can potentially deliver over identical time periods. Clearly, the good portfolio is the most superior performer, while the ugly one occupies the lowest rung.

As investors will no doubt agree, a portfolio is as effective as the assets contained in it. The right kind of choices will boost its performance; the wrong ones will obviously bring down overall returns. Such choices, to be ideally based on the investor’s risk profile, must be made in line with certain principles. Let me briefly outline three key tenets:

  • Diversification
  • Cost efficiency
  • Convenience

A well-diversified portfolio is more often than not a clear winner. Several parts of it may malfunction at any given point, while some of the others may each turn in a splendid performance. The investor must ensure there is adequate diversification. Too much dependence on a single asset class (or just a handful of asset classes) will not be quite beneficial in the long run. Diversification must be effected in all ways possible. Risk, for instance, must be spread across geographical limits as well.

Behind The Scenes

A cost-efficient portfolio is very much the need of the hour—especially because of the fact that costs (look at them when they pile up over a period of time) are among an investor’s most terrible foes. The average participant must be fully aware of all the expenses that are involved; these usually stem from transactions and can take the shape of brokerages, commissions, loads and so on. Moreover, there is the issue of taxation. Added to transaction costs, taxes too can deal a body blow to one’s overall returns.

A good portfolio must also be easy to handle. The number of assets that it comprises, for example, must not be too many. A full range of complicated transactions executed across various assets, particularly the ones that may have been conducted too quickly over a relatively short span of time, will make it appear unwieldy as well.

In this connection, the investor will be well advised to bear in mind the following points:

1. A broad-based portfolio spread over all the vital asset classes will ultimately prove useful.

2. Frequent buying and selling of holdings will add to expenses, and can also result in sundry charges and even considerable taxable gains.

3. The number of holdings should be kept in control. This will not only simplify matters but will also reduce the probability of owning me-too assets.

Now, if these are the features of a good portfolio, it goes without saying that a bad portfolio is marked by just the opposite. It is either too spread-out or too narrow. It either has too many components (with several identical ones) or it is needlessly concentrated. It will also have a few stark under-performers. The latter, collectively speaking, are likely to be a major drag—the superior holdings will be weighed down by the impact of the under-achievers.

The committed investor, therefore, must regularly explore the possibility of trimming such a basket of securities. A six-monthly exercise may be recommended; this will reduce flab and make the residual lot a bit easier to manage.

In fact, this raises a rather formidable issue—liquidity. At all points, a critical part of your portfolio needs to be kept as liquid as possible. In other words, too much exposure to illiquid assets will be counter-productive. So going slow on lock-ins is what I can recommend.

Edit Out What’s Not Needed

A portfolio marked by an overwhelming allocation to, say, real estate, will not be as helpful as it may seem in the first place. Real estate, after all, often can be quite illiquid. It is certainly not easy to sell real estate in all locations or at all times of the year. Price discovery in the property market is indeed a challenge; negotiations between buyers and sellers can drag on for a very long time. Further, there are a host of legislations to deal with.

Similarly, such difficult issues may also arise in the case of assets like art and physically-held commodities (typically, in the traditional Indian context, gold and silver). It is extremely tough to sell artwork done by an artist who has fallen out of favour in the market. Galleries often tend not to touch certain artists who are not “saleable” any more. Such assets will, thus, be considered illiquid by most investors who want to cash out easily or with minimum fuss.

The ugly portfolio will be all this and a lot worse. A combination of horrific choices, in short. Too disproportionate, illiquid for most parts, replete with all sorts of sub-standard securities. For all you know, it will contain all sorts of unsavoury holdings—stocks that are hardly quoted on the exchanges, closed-end mutual funds, property that potential buyers will definitely avoid, art that no decent curator will want.

The latter will typically come with baggage—perhaps a high exit fee, or a lien or two, or even a legal charge that can be removed only through a court-administered process. There will be execution costs to contend with or perhaps tricky paperwork that make life difficult for the holder.

The worst sort of portfolio has to face long-drawn (read: costly) legal wrangles. Such a scenario is not uncommon in a country like ours, especially in areas such as real estate.

Well, a good portfolio can be made smarter and sharper with the help of professionals. The latter can appear in the form of licensed intermediaries—a financial planner, maybe. When engaged, such an intermediary will help its owner take all the right decisions. Like, rebalance when necessary. Or book profits when the situation is conducive. There will be a fee, of course, for professional services rendered. However, the critical idea, as always, is to improve quality, eliminate risk, and ultimately fetch higher returns.  

The astute investor will appreciate such a strategy. He will want an ideal basket of securities—a malleable portfolio that can emerge as a self-fulfilling prophecy, one that lends itself to changes in order to stand the test of time. Or one that can withstand sudden shifts that take place in market conditions.

As a sombre yet humorous quip goes in the famous Eastwood flick, “People with a rope around their neck don’t always hang.”

The author is Director, Wishlist Capital

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