Diwali Cleanse But for Your Investments: How to Remove Risky and Underperforming Assets from Your Portfolio

It’s Diwali week and you must be busy cleaning the house. As you eliminate useless stuff and clear out clutter, do the same with your investment portfolio. You may have some poor quality stocks that enhance the risk of the portfolio. Underperforming mutual funds could be dragging down overall returns. Or you may simply have invested in too many plans, making the portfolio difficult to manage and monitor. There could also be some tax-inefficient instruments in the portfolio.

You need to identify these unwanted items and realign the portfolio to match your risk tolerance. This will not only help improve profitability but will also ensure that you achieve your financial goals with ease. Let’s start the exercise with a simple question: How many stocks and mutual funds do you have in your portfolio? “If you can’t answer how many funds or stocks you own, it’s a sign that you’ve lost track of your investments,” says Vidya Bala, co-founder of PrimeInvestor.in.

Abhishek Wadgaonkar (see image) sought help from ET Wealth to clean up his mutual fund portfolio before Diwali. The Aurangabad doctor has been earning good returns from his aggressive investments in mutual funds. However, its portfolio is heavily skewed towards small and mid-cap funds. “There is too much froth in the small and mid-cap space. The past performance of these funds is not likely to be repeated,” warns Raj Khosla, CEO, MyMoneyMantra.com.

Market experts are aware of this risk. Many fund houses have stopped accepting lump sum investments in their small cap funds. They consider that valuations have risen too much. Other fund managers sit on cash, waiting for valuations to fall before deploying the money. Sitting out could mean losing if stock prices continue to rise, but it also protects the portfolio against a downturn. “We are cautious and a significant portion (of the small-cap fund corpus) is in cash, and in large- or mid-cap companies. The market is irrational right now. Therefore, we do not chase returns and focus on capital protection,” Anish Tawakley, co-CIO of ICICI Prudential Mutual Fund, said in a conversation with ET Wealth earlier this month.

Investors like Wadgaonkar should pay attention to this. Although it has a high risk appetite and a long-term investment horizon, exposure to the small and mid-cap segments should not exceed 40% of the portfolio. Large cap stocks are more resilient and can offer stable returns.

Much depends on the time available. If your target is too close, even large-cap stocks can be risky. Ravinder Nath (see photo) will retire in two years and his son’s marriage is scheduled for next year. However, 75% of his portfolio is in stocks and equity funds. “Investing money in stocks with a horizon of 1-2 years or less is akin to gambling,” says Rajul Kothari, partner at investment advisory firm Capital League. “You need to rebalance your portfolio towards debt because two of your goals will be met in the next two years. Prioritizing security and liquidity is essential,” he adds.Clean up the mess
If reducing portfolio risk is important, so is getting rid of stragglers. Experts say investors should periodically review the performance of stocks and funds in their portfolios. Investors tend to accumulate many different mutual funds in their portfolios. “It is not uncommon to see mutual fund portfolios with 30 to 35 different schemes,” says Khosla. Some do it because they want to invest in the best performing schemes. Others try to diversify their holdings by spreading their money across multiple schemes.

Abhishek Wadgaonkar, 40, Aurangabad:Reduce risk by reducing exposure to small and mid-cap funds.
Note:An aggressive investor who has achieved good returns from small and mid-cap funds. It has significant exposure to these segments as small-cap funds account for 18% of its 1.4-crore mutual fund portfolio, while mid-cap funds constitute 27%. The remaining 55% is in large-cap and flexible-cap equity funds.

EXPERT ADVICE:RAJ KHOSLA, CEO,MYMONEYMANTRA.COM
Note:“There is too much froth in the small and mid-cap space, and past performance is not likely to be repeated. Even in normal times, the allocation to the small and midcap segments should not exceed 40%. Get out of some small and mid-cap funds to reduce risk in the portfolio.”

Both are wrong reasons to invest in more funds. The winners change every year, so an investor will end up adding more funds to their portfolio if they are looking for returns. Meet Anita Rao (see image), who has been investing in mutual funds for the last 6-7 years. He started an ELSS scheme to save taxes, but abandoned it when his performance declined after a few years. He then launched SIPs in the best performing schemes. Some ETFs also caught his attention. An advisor convinced her to invest in NFO. Over the years, Rao has amassed 32 schemes in his portfolio. “My portfolio may have too many funds, but that also makes it well diversified,” he says.

Anita Rao, 35, Bengaluru: Review fund performance and get rid of constant laggards.
Note: You started investing in an ELSS fund to save taxes six years ago, but stopped when your returns declined. He then started SIP in the best performing schemes, ETF and NFO. Over the years, it has accumulated 32 plans in its portfolio. She believes this makes her portfolio well diversified.

EXPERT ADVICE: VIDYA BALA, CO-FOUNDER, PRIMEINVESTOR.IN
Note:“Having too many funds risks generating mediocre returns. When you invest in more schemes, you may alter the original risk profile of the portfolio. It is also possible that the new plan simply duplicates the strategy already being followed by another fund in the portfolio.”

That is a widespread misconception. Investing in multiple schemes does not really diversify risk. “When you invest in more plans, you can alter the original risk profile of the portfolio. It is also possible that the new scheme simply duplicates the strategy already being followed by another fund in the portfolio. Furthermore, having too many funds risks generating mediocre returns,” warns Bala.

This Diwali, ditch funds that have consistently underperformed their benchmark indices and respective categories for more than 2-3 quarters. If there are a pair of identical funds in the portfolio, keep the one with a higher rating and discard the others. This will optimize your returns.

Rebalance the portfolio
Diwali is also a good time to rebalance your portfolio. As any investor will know, asset classes do not move in the same direction or at the same pace, and differential growth changes the composition of the portfolio mix over time. For example, stocks have risen around 35%, gold 27% and fixed income options have returned between 7% and 8% since last Diwali. If, a year ago, your desired allocation was 60% in equities, 30% in fixed income and 10% in gold, the allocation in equities would have increased to around 65%, while the allocation in debt would have decreased to 25% . The portfolio is now exposed to more risk than you can accept.

Ravindra Nath, 58, Pune: Targets are very close, so stay away from volatile assets.
Note:As a long-term investor, he has almost 75% of his Rs 1.5 crore portfolio allocated to equities. The mutual fund portfolio is a mix of small, mid and large cap funds. It also invests directly in stocks. Nath is scheduled to retire in two years and his eldest son’s marriage is likely to be next year. Another child may marry in 3 or 4 years.

EXPERT ADVICE:RAJUL KOTHARI,PARTNER,LEGA CAPITAL
Note:“You need to rebalance your portfolio towards debt because two of your goals will be met in the next two years. Therefore, security and liquidity are essential. Switch from direct investments in stocks to fixed deposits or arbitrage funds for the marriage that will take place next year. Switch from equity funds to debt funds a year before the next wedding.”

“To avoid this, you should periodically review and rebalance your investment portfolio,” says Bala of PrimeInvestor.in. “Review your original asset allocation, identify significant deviations, and abandon redundant or underperforming investments,” he adds. Rebalancing controls risk by restoring the original asset allocation. Backtesting studies show that investors who periodically rebalance their portfolios and stick to a predetermined asset allocation tend to outperform investors who keep their portfolios static and let them flow with the market.

“A deviation of five percentage points or more from your original allocation is usually a sign that rebalancing is necessary,” Bala says. He recommends conducting a semiannual portfolio review and annual rebalancing, noting that no rebalancing may be necessary if the portfolio is well aligned.

Getting rid of tax inefficiency
Keep taxes in mind when reviewing and rebalancing your portfolio. Investors tend to opt for fixed income instruments because they offer assured returns, but do not take into account the after-tax return. Fixed deposits and bonds may appear stable, but their returns after adjusting for taxes and inflation can be disappointing. For example, if the investor is in the 30% tax bracket, a fixed deposit offering a return of 7% will yield only 4.9%. “After accounting for inflation, the actual return could be negative,” says Prableen Bajpai, founder of Finfix Research and Analytics.

Sanjay Parashar, 31, Jaipur: Opt for arbitrage funds instead of tax-efficient fixed deposits.
Note:Though he mainly invests in equity and equity mutual funds, he has also invested Rs 10 lakh in fixed deposits as part of the fixed income part of his portfolio. However, the returns are not very good because in the 30% tax bracket, the return is less than 5%.

EXPERT ADVICE: PRABLEEN BAJPAI, FOUNDER, FINFIX RESEARCH & ANALYTICS
Note:“Interest on fixed deposits is fully taxable. Debt funds are a better alternative although there is no longer any benefit of indexation. Earnings are taxed only at withdrawal. Arbitrage funds can offer higher returns and profits up to Rs 1.25 lakh are tax-free after a year.”

That’s something that worries Sanjay Parashar (see photo). The Jaipur-based finance professional invests in equity and equity funds, but also has around Rs 10 lakh stashed away in fixed deposits. Bajpai says Parashar should move from fixed deposits to debt funds or arbitrage schemes. “Interest on fixed deposits is fully taxable. Debt funds are a better alternative although there is no longer any benefit of indexation. Arbitrage funds can offer higher returns and profits of up to Rs 1.25 lakh are tax-free after a year,” he says.