Rising markets distort portfolio allocations in two ways. The first is by the sheer improvement in valuations, equity portfolios rise and hence take a significantly larger portion of the asset allocation than previously planned. The second is by getting carried away in the euphoria of rising markets and further increasing exposure to equity assets in the greed for maximising near term returns. It worries me when investors look only at prospective return while paying scant attention to risks. It is the role of an investment adviser to steer clients towards their originally agreed upon Investment Policy Statements and take a second look at what they really wanted not more than probably a year ago. It is at times like these when an Investment Adviser should play spoil sport and help clients in avoiding excessive risk taking. As the tide rises every boat is lifted and suddenly everyone becomes a superlative portfolio manager. We start believing in the inherent superiority of our decisions and become blind to risks that we would otherwise have been far more circumspect about.

There is no doubt that India is on the cusp of a strong rebound. So while on one hand I am advocating a watchful approach, what should clients be doing ? – should they be allowing such golden opportunities to pass by?. My belief is keeping high levels of liquidity that buffers for tail risk events is advisable and also provides optionality when and if asset prices significantly correct. Second even if clients wish to increase equity exposure, I would prefer taking a systematically investing plan into a index linked market wide highly diversified exposure rather than increasing exposure to specific stocks. This will address both timing risks and specific stock risk and at the same time give clients equity exposure. It is likely with this approach, portfolios will underperform in the short run especially in a rising market environment. However when sudden shocks rock the boat we will significantly outperform and more than make up for the earlier underperformance.

A second aspect I wish to touch upon is my current discomfort with the level of outperformance that your portfolios have achieved over the benchmarks that each of you have chosen. This level of outperformance will result in significant fees payable to the investment adviser i.e yours truly. Once this fees is paid, clients are left with no protection for future underperformance of the portfolio. How then should we structure compensation to incentivize me to keep a long-term view? After all when the client is expected to keep a long term view why should the investment adviser not ? The answer came to me by applying one fundamental rule I had set my self – skin in the game. i.e Do I have as much invested in this as my clients ? Will I be affected when my clients’ portfolios suffer?

The solution I have come up with is simple. Every year I should take out only 25% of the fees payable and allow the rest to remain within client portfolios and adjust the high water mark to reflect this. If there is future underperformance, my fees will first be eaten into and thus I will stand to lose my fees if there is underperformance in future years. You - the client are thus protected (to the extent of the unpaid 75% of the fees) against future underperformance. Do note that by you retaining 75% of my fees payable, when your portfolios perform, my retained fees in your portfolio will also perform !! So I still stand to gain when you gain. By delaying my gratification, I am forcing myself to think long term for both the client and myself.

Watch these two videos that talk about delayed gratification in children:

Walter Michel on his marshmallow experiment

Joachim De Posada on delayed gratification and success