A defensive portfolio is warranted at this time to ensure your wealth survives any shock, and you also benefit from it
Shashank Khare| Fri, Jul 26 2013. 12 56 AM IST|LiveMint.com

These are trying times for Indian investors. The seemingly inexorable rise in the rupee, real estate and the equity markets when United Progressive Alliance (UPA) was not a four-letter word is long forgotten. The rupee, hard-hit by the global emerging markets pull-back, is creating the wrong records every week. Wondrous tales of house prices doubling every quarter are now rarer than a honest politician, and the equity markets have gyrated wildly offering investors return-free risk. Add political stasis and galloping inflation into the equation and all the ingredients for a perfect wealth-destructive storm are in place.

In such an environment, even seasoned professionals are at a loss about where to invest. Pessimism about India is on the rise and some smart investors have either already decamped or are in the process of doing so. However, globally the picture is not that much more enticing. Developed economies are still on their knees, with the weak US recovery wedded to the ultra-easy monetary policies of Ben Bernanke. Even slight hints to withdraw the monetary drug cause markets to swoon globally. Europe refuses to acknowledge that it is in a depression. Politicians are stubbornly pressing on with policies that are eroding public support for the European ideal. Back in Asia, China’s delicate attempt to re-balance its credit-dependent, investment-led economy is wobbling, while Japan has turned its economy into a laboratory to test the latest monetary dogma. It is little wonder that across the world, markets are jittery and volatility on the rise.

This litany of economic woes is not new, and unless you’re an academician, you’re likely to be interested in the solution rather than the problem. The first step towards constructing a portfolio in the current environment is paradoxically submitting to your optimism bias. Policymakers are unlikely to suddenly discover a magic bullet, but the innate trend of civilization is towards progress and growth. Economic storms unfailingly appear, but they also invariably dissipate. Therefore, you must choose investments that increase in value as growth revives (and not lock yourself in a bunker with gold bricks, as we’ve mentioned before).

However, to paraphrase Keynes, we set ourselves too easy, too useless a task if we invest solely on the basis that when the storm is long past, the ocean is flat again. Astute investors are acutely aware of path dependence of investments. You may have bought Apple stock at its peak in 2008, after people believed that the crisis was over after the Bear Stearns rescue, but if you couldn’t afford the decline of more than 50% in the aftermath of Lehman Brothers, then the eventual 800% rally was moot. Path dependence matters not only for leveraged investors who are forced to close their investments due to the inability to meet margin calls. It also matters for the rest of us unleveraged investors because even though we aren’t forced, we tend to panic or lose patience and exit from a potential winner. Moreover, being fully invested when the market is falling means you cannot take advantage of reduced prices to increase your investment.

Therefore, optimism needs to be balanced with situational awareness. Blindly investing in equities, real estate and other risky assets at this juncture may sink your portfolio. Global imbalances that led to the credit crisis in 2007 have not been resolved, they have only been submerged by a tidal wave of easy money released by central banks across the world. At some point, the tide will recede and take away those who have gone in too deep. Unfortunately, timing the entry and exit from an investment is as difficult as it is critical. The gift of perfectly timing the market is only available to the Rajaratnams of investing. The rest of us have to make educated guesses about how the situation will evolve and the possible endgames.

Looking broadly at both Indian and global situations provides some guideposts to constructing a portfolio that retains some upside when the economy is on a surer footing while protecting against catastrophic consequences.

The two big trends that are going to determine investment returns in India are the domestic political situation and international interest rate environment. The former will determine the long-term growth trajectory. An able and stable government committed to reforms can set the stage for the next burst of growth similar to the 1991 reforms. Unfortunately, the likelihood of such a government forming after the 2014 general election is low. This means that the risk of the Indian economy stagnating is fairly high. The only asset that recommends itself in such a bleak scenario is real estate and that too purely for perverse reasons. Since real estate is the dominant asset in the political class’s portfolio (a cursory look at the cabinet’s assets shows the real estate bias), it is likely to retain its value and appreciate. Historically, this has been the asset class that performed the best during the darkest days of the socialist secular democratic republic. Real estate also captures the upside in case the Indian polity gets its act together and this bleak assessment is belied. A thriving economy will naturally increase prices. However, care must be taken in selecting your investment property since an “off-golf-course” Gurgaon condominium that is nowhere near the golf course is unlikely to justify its premium price.

In the near term, the monetary policy stance of the US Federal Reserve (Fed) along with the evolving European and Chinese situations are going to be the major determinants of investment returns across Indian assets. The Indian economy is now more intertwined with the global economy, and the large influx of foreign institutional investment has made returns from Indian equities more correlated with global investor confidence. As the recent wobbles following the interpretation of runes from the Fed show, nearly every market is propped up by the actions of central banks and so too is investor sentiment. At some point, this unstable equilibrium is likely to break and provide a superb opportunity to buy equities at distressed levels as FIIs and investors take fright. Therefore, it is better to keep money aside to buy at a bargain later than chase the rally now.

With such a despondent outlook, pessimists may argue that it is better to exit India. However, decamping abroad is no panacea since the near-term trends are global and thus will affect all markets. Moreover, the relative severity with which different markets will be affected is difficult to quantify a priori. Therefore, it is a gamble where you have exchanged a known, albeit pessimistic, environment for a relatively unknown one. Unless you know both the economic and political forces at work, such a gamble may not pay off. For example, London property may look like a sure winner purely on high rental yields, which are more than 1% above mortgage costs, coupled with decent price appreciation (5% year-on-year until May). However, a domestic political backlash against foreign-owned property or the relaxation of planning permission are just two of many factors that may significantly dent returns for foreigners rushing to invest.

Ultimately, a defensive portfolio is warranted at this stage to ensure that not only your wealth survives any economic shock, but also you are in a position to benefit from such a shock. The outlook may be bleak, but there is still an opportunity for the sagacious. As any Indian knows, India reforms and recovers from crisis to crisis.

Shashank Khare is an investment professional andwriter. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word. Having successfully batted through the crises, he now indulges his passion for economics, finance and policy through writing and trading.

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