Portfolio management and asset allocation lessons from the Mahabharata

Each portfolio has its own risk and return strategy, and it grows at a specific rate to deliver the required corpus to meet its goal. Most of us are comfortable with such a strategy. But, is this the right approach?

This is a monthly column in Mint by Priya Sunder, Director and Co-founder of PeakAlpha

“Where Arjuna went, the battle turned,” the Kauravas lamented as they fought the Pandavas in vain in the Kurukshetra war.

On the 11th day of the battle, Drona, trapped the enemy in complex formations. Krishna, Arjuna’s charioteer, anticipated this devious strategy. He constantly repositioned Arjuna, angling and manoeuvring his chariot and slipping through army gaps, circling large infantry, and avoiding direct traps through speed and manoeuvrability.

The mobility of armies can make or break a war. Rapid deployment of resources, warriors, and chariots helped Pandavas win the war, despite a much smaller army and far fewer resources than the Kauravas.

Money works the same way

The mobility or fungibility of money in achieving your life goals is not very different from the mobility of resources during wars. Fungibility essentially means that each unit of money has the same value and can be used to buy or sell towards any need.

A ₹2,000 note can buy you dinner or a train ticket. It does not need labels like travel money or food money. The note is completely liquid and interchangeable and can move freely across need and time.

Yet people often treat it as non-fungible, and create discrete money buckets, where each bucket caters to a specific goal, such as home purchase, children’s education, marriage, or retirement.

Each such portfolio has its own risk and return strategy and grows at a specific rate to deliver the required corpus to meet the goal. Most of us are comfortable with such a strategy because it seems logical, clean and organized. Most intelligent and meticulous investors would plan their goals in this manner. However, this is a flawed approach compared to a holistic approach to investing. Here is why:

The five reasons

First, based on the customer’s age, financial situation and risk appetite, an overall target asset allocation is typically established. In the siloed approach, each bucket may have a different allocation between equity and debt with varying levels of risk and volatility.

Some individual goal portfolios might be too conservative, while others are too aggressive. For example, an overall portfolio may require a 50% allocation to equity to comfortably meet all long- and short-term goals, whereas a siloed portfolio could result in an 80% allocation to equity in some cases and zero in others, leading to an overall allocation that is less or more than the most optimal level.

This mismatch in asset allocation can cause portfolio drag, reduce efficiency, and lead to higher or lower risk than necessary.

Secondly, just as we have the flexibility to invest a rupee for any need, we must also be able to redeem the same rupee elsewhere in the portfolio. Ideally, when funds are needed, we should exit from the weakest instrument in the portfolio.

Redeeming from a siloed portfolio simply because it has been earmarked for the goal may lead to exiting a better-performing asset rather than the weakest. It is important to identify the weakest link, so you eliminate underperforming assets to either consume or redistribute across better-performing assets.

Third, siloing across different portfolios may lead to tax inefficiency, either during investment or redemption. Often, people earmark a recently received sum of money for a goal that is coming up soon.

They may, for example, invest the receipts in a short-term bond fund for the upcoming goal, which upon redemption may be taxed at their marginal rate, leaving them with lesser funds in hand compared to a redemption from another fund where the gains or tax could have been lesser or perhaps none.

Since money is fungible, the received money could instead have been invested for the long term, and the upcoming need for money could be funded from the weakest instrument in the existing portfolio.

Fourth, cash and bonds play a far greater role beyond just ensuring safety and generating income in the portfolio. They are the fuel to fire up your portfolio when markets decline. These cash and bond holdings can then be deployed to purchase more equity during a market downturn.

An asset allocation strategy does just that–ensure the investor buys low when the markets are down and sells high, when the markets rise, to optimise overall portfolio returns. It is hard to do this efficiently when money is trapped in various siloes.

Fifth, while it seems logical and intuitive to create short, medium and long-term goal buckets to meet specific outflows, you may run the risk of consuming all the near-term liquid, safe assets for short-term spending, leaving the long-term bucket skewed towards equity. Such an approach will increase risk in the portfolio in your senior years, clearly an undesirable outcome.

Arjuna’s agility at circumventing enemy traps, and his ability to appear wherever the Pandavas needed him the most provided his army the flexibility, resilience and vital advantage to respond to the Kauravas’ shifting strategies and win the Kurukshetra battle.

Your money should work the same way. Drop the silos and let your capital move freely across goals and time. Give your portfolio Arjuna’s advantage to create the fluidity to meet planned or unforeseen goals.

Priya Sunder is director and co-founder, PeakAlpha Investments. Views are personal