Positioning portfolios to benefit from uncertainty and volatility
As I highlighted in my previous post, the world is more uncertain than ever before. A majority of academicians and so-called experts are busy in predicting the impact on economy, financial markets and otherwise. None of them can have and will have any conviction of what is left to entail. While the long-term trajectory is relatively easier to predict, in the short-term , it is important to focus our attention on preparation for all circumstances .
As Nassim Taleb highlights in his book Antifragile, the future unfolding of unpredictable events has the potential to affect our situations in either of the three ways.
i) Harm us
ii) Neutral to us
iii) Benefit us
Rather than spending our he time and energies on predicting macroeconomics , we should focus on positioning ourselves to be antifragile and benefit from the uncertainty.
Lets discuss how we can apply this to our financial portfolios. To sleep sound and be antifragile, it is important to be be positioned in a way that one is exposed to the unlimited upside , while limiting the downside to the minimum (at a comfortable level).
In this environment wherein valuations are stretched more than earnings of the firms , it is natural to feel uneasy over one’s portfolio regarding the possibility of potential reversion to mean rationalising the valuations and affecting our unrealised gains . On the other hand, as nobody knows till when the valuations can continue to rise, we don’t even want to miss out on the gains, by selling our investments . Who knows if this could be a long bull rally.
So how can one’s equity portfolio be positioned so that no matter which way the future unfolds, we are prepared to reap the benefits. . I recommend either of the two approaches below.
- Keep only a limited portion of your portfolio in equities-
If you are a long-term investor , assess how much absolute value of portfolio decline (in near term) can you handle with equanimity. As principles of value investing suggest, one must be able to handle the downfalls of 50-60% in portfolio with equanimity,
For example- If my ability to see my portfolio decline is limited to Rs 5 lakh in the near term, I must not invest more than Rs 10 lakh in equities (assuming 50% decline). This is a simple way to restrict your downside while keeping the portfolio exposed to potential upsides. Knowing your capacity and ability to handle the above must direct your proportion of wealth in equity markets.
2. Buy insurance and Hedge your portfolio against severe declines.
If you dont buy the idea of having very minimal exposure to equities , another alternate method is to buy hedge on your portfolio. Different hedging strategies could be deployed , with the simplest one being buying the Put Options. Eg. If you have a well-diversified portfolio, puts could be bought on Nifty , that will avoid your downside. You can chose the strike price as per the level of downside you want to protect. Of course, the more protection you need, the higher would be the rate of the hedging.
The benefit of this approach is that you can continue to reap upside (if market ends up in a bull run), while keeping your downside protected. No doubt, your returns would be affected a bit due to the premium you are paying for buying portfolio insurance. But, nothing comes for free and this could be a good trade-off to sleep sound and still reap the potential upside from market irrationality.