The textbook definition of financial freedom is to have sources of passive income to support your lifestyle expenses. The traditional approach of ‘Medium Risk’ portfolio of 40/60: Stocks/Bonds – typically advised to anyone and everyone – helps attain financial freedom only by reducing lifestyle expenses and not by having sufficient inflation-protected income streams.
This is a very conservative and suboptimal approach. One can maximise wealth creation and optimise returns only if one invests predominantly in equities. Therefore, absolute financial freedom is achieved when one can freely invest in equities with confidence by attaining a state of mind free from the generic tendencies of greed & fear.
There are two parts to how one can gain this confidence. The first is to understand the genesis of these biases or tendencies. The human brain is hard-wired to function in certain ways especially when there is a threat perception or craving/addiction. One such behavioural bias is loss aversion where the person assigns higher priority to loss avoidance than gains. Due to this, investors tend to settle for lower returns in return for notional capital protection.
Similarly, there is a bias called herd behaviour leading to irrational rallies and sell-offs in the market. While behavioural finance is a separate field to learn more about these, this is not the agenda for this article so we can move forward with a realisation that one may naturally make an irrational decision because of the functioning of the human brain and hence one needs to guard against such tendencies.
The second part of gaining confidence is to know and understand clearly what one is doing. A lot of the above behavioural biases come into play because investors do not have even the basic fundamental clarity about equity markets. Many see this as a speculative game to make some quick bucks or buy stocks as lottery tickets that can multiply their money in a few days.
The first thing to recognize is that the equity market is not a short-term betting market but one of the most important asset classes where one needs to invest the largest chunk of one’s current assets and future income streams.
Also, equities are one of the best-performing asset classes over the long term. Therefore, the intention is to remain invested in equities for long periods without the urge to move in or move out based on the market ‘noise’ so that one benefits from the long-term performance trend. Remember the long term returns from the market are around 15% despite all the events such as the US Financial crisis of 2008, Covid-19, Demo, Dotcom Burst, Harshad Mehta Scandal, etc.
It is equally important to recognize that equities are a risky asset class hence one needs to have a ‘Safety-first’ approach. The mantra is not to chase returns but safety and reducing risks so that one survives in the long run and also achieves satisfactory returns. Once all the ways in which one can lose capital permanently are understood and the ways of guarding against them are developed, then one can Invest in equities with confidence.
The aim is to remain invested in a subset of the market which has lesser risk. One type of risky companies that an investor needs to stay away from are capital destroyers. These have weak business operations and high-debt weak balance sheets. Next lot to be avoided can be called Capital Eroders – companies that are consistently earning below the cost of capital.
Finally, the last lot to be avoided may be called Capital Imploders – companies that are fundamentally strong and also well-recognized by Mr. Market and hence are priced at premium valuations. Whenever the over-optimistic and heroic assumptions become untrue the price implodes.
Once these three types of companies are removed from the broader market portfolio and optimise on future growth prospects one can invest in a SuperNormal portfolio of capital multiplier companies which are fundamentally strong businesses with strong balance sheets and bought at attractive valuations.
In this SuperNormal portfolio one also needs sufficient diversification in terms of holding a number of stocks, a number of sectors and a number of growth themes. Finally, one needs to be a die-hard optimist on the Indian economy to invest with confidence.
Ashwini Shami, smallcase Manager, EVP & Portfolio Manager OmniScience Capital