For investors, the Adani affair proves (yet again) that the basic principles of investing work very well. Yawn.
16-Feb-2023 •Dhirendra Kumar
Politics and conspiracies aside, what exactly is the takeaway for investors from the events surrounding the Adani stocks over the last few days? It's more than a little hard for investors to keep a cool head when stocks are falling hard, but here's a counterintuitive take: the basics of equity investing are alive and well, and investors who stick to those basics have done well out of the Adani stocks.
Everything that is being discussed about this issue by the talking heads on TV and elsewhere may (or may not) have the greatest relevance to politics and financial regulations, but it has little relevance to actual equity investors who simply stick to the basics of investing.
And what are these basics I'm talking about? The obvious ones: diversification, asset allocation and cost averaging. In fact, the Adani affair is a great teaching moment in how these simple principles keep you protected from unexpected adverse events that may hit a stock or a sector or a group.
Let's look at this one by one, how each one does it's job. Diversification is supposed to be the most important part of any investment strategy. The idea is simple - you are supposed to spread your investments across different sectors and industries or business groups so that bad times in one may be offset by another. This is hardly a strategy unique to business or investing - 'don't put all your eggs in one basket' is probably one of the first proverbs that one comes across in life, and one whose benefits are self-evident.
Any investor who has even the basics of diversification in place would not have had more than, say, 10 per cent of their equity holding in one business group. That means that if because of some unique challenge, one business group's stocks halved in value, the total impact on the holdings would be perhaps 5 per cent. That's a decline, sure. However, it's hardly a disaster - any seasoned equity investor would take a 5 per cent decline without blinking.
The idea of diversification leads one naturally to that of asset allocation and its close twin, asset rebalancing. In fact, following these principles would have meant that anyone who was invested in the Adani stocks would have made a lot of money out of them, AND would have protected those gains. To appreciate this, let's go back to the basics. Let's say your allocation principle says that you must not exceed an exposure of 10 per cent of your portfolio on a particular business group. Over the last few years, as the Adani stocks zoomed up 5 times to 20 times, far faster than the rest of the market, they would have repeatedly broken this limit.
When that happened, what would sensible investors have done? They would have sold enough of the Adani stocks to keep the total under 10 per cent, or whatever their limit would have been. In effect, they would have taken their returns out and deployed them elsewhere. This is the essence of asset rebalancing. There's nothing 'Adani' about this. The most common form of asset rebalancing is the broad one between equity and debt and that's something that's widely practised by any investor who is even minimally systematic in their approach.
The word systematic brings us to the third basic principle that we can observe here, which is that of investing in any stock over a period of time and averaging one's costs. Since we are talking about Adani as an example here, it is notable that these crashed stocks are all up 5 times to 10 times over the last five years! Investing gradually over a period, diversification, having an asset allocation limit and rebalancing is all that it takes to save an investor from even a big corporate which has produced more hot air than almost any other for a decade.
So, the moral of the story is the most boring - and the most useful one - ever: sticking to the most basic principles of investing works - that's why these ideas became the basic principles. What a surprise.
Suggested read: Facts change, principles don't