Intergenerational Investing: The challenge of protecting and preserving wealth across generations

Most of us, when we start investing, it is with a very small corpus, unless we are lucky to have an inherited portfolio. The lure of making a lot of money in the stock market beckons. Reading the exploits of legends like Buffett or Jim Simons or our very own Rakesh Jhunjhunwala, we dream big. The problem we try to solve is wealth creation.

On the other hand, there is another class of investor, who has a completely different challenge. They have made their money, mostly from their businesses, and have either sold out or taken out a substantial portion to create a sizeable portfolio. And now they wish to invest it. This takes many forms – family offices, family trusts, family portfolios etc.

In the last few years, I have been associated with a few large family offices and have gathered a fair understanding of the psychology of this type of investment. The most important aspect of this form of investing is not wealth creation but wealth preservation. Here, the objective is not to look for the next multibagger but to ensure that the family retains buying power at the same level in the next generation.

Capital Preservation: play defence before offense

When I was first asked to help guide the investment of one such family a few years back, in the midst of Covid, it gave me a great sense of responsibility. Here the capital is all that the family had. It was irreplaceable. If it was lost, it can never be replaced. It represented a lifetime of effort, earnings and savings of the family. Now that the business was sold, there was going to be no more capital coming in. So, capital preservation had to be the most important factor.

The question is how to preserve capital. I use multiple ways to manage risk.

Risk Management: modes of survival

First and foremost, my focus is to buy high-quality businesses. The longevity and endurance of a business becomes one of the most important criteria for stock selection. This ensures a very low probability of permanent capital loss.

Secondly, I use a stop loss. This sounds sacrilegious to many value investors, but I am strongly of the belief that no investor can know all that is to know about any investment. I mean, even promoters don’t know everything. We deal with the future when we invest. And the future is always uncertain. So, I use a stop loss. It is my insurance against catastrophic loss. This provides a floor to the loss I can take at any time and provides a fair deal of comfort to me and the investor family as well.

Thirdly, I diversify. Depending on the size of the portfolio, the diversification varies. Usually, I prefer having 10-20 stocks in my portfolio. But for large portfolios, I sometimes would have more stocks.

Asset Allocation: spread it out

Another aspect is to have multiple asset classes in the portfolio. Equity, bonds, gold, silver and real estate are the ones that are good options. As I am personally only focused on equities, I suggest they consult with specialists in each area. Moreover, a broad per cent allocation needs to be agreed upon and an annual check is needed to adhere to the allocation.

Even within equities diversification across sectors is important. No sector should become too large to hurt the portfolio.

Defensive factors to the fore

In factor investing parlance, while constructing a defensive portfolio, the preference should be towards selecting stocks which correspond to factors such as dividend, value, large size etc. Sometimes a combination of such factors could be a good starting point. For example, stocks which are large-cap with a good dividend yield could be a good choice. Or stocks which are cheap and offer good dividend yield.

Market timing: tactical market timing

Market timing, another topic which is anathema to the investing pundits, is something which everyone wishes to do but admits not to try!! As a student of the craft of investing, I always try to get better at the craft. And that includes market timing. In fact, observing markets and participants over the years has taught me that timing is one of the most critical aspects of investing. If you are too early to enter you will get sub-par results. If you are too late to exit a stock, again you will get a sub-par result.

Market timing can be attempted in many ways, and none are foolproof. You can use technical or quantitative analysis. You can use absolute or relative valuation-based methods.

Active quant-aided: custom indexing can help

When you start playing defence you may be drawn towards a broad index like Nifty and invest passively. Although it is a perfectly good course of action, a much better approach is to build a custom index based on your preferences.

I have used simple quantitative methods to create a customised index which improves upon the vanilla Nifty index by changing the methodology of stock selection, sector weightage and entry and exit criteria.

With large portfolios, more fundamental oriented long-duration quant models are required to be implemented.

Playing offense

Some amount of playing offense is needed to enhance portfolio returns. When we look at building a portfolio from a factor investing model, offense would mean adding growth and momentum as major factors in the portfolio. Although commonly momentum is synonymous with short-term trading, it need not be so. Longer-term momentum strategies are also extremely effective and can be used in portfolios of large size.

Summary

Over time and with increased portfolio size, the objectives of an investor can change. Kahneman & Tversky introduced the prospect theory, for which Kahneman later received the Nobel Prize. At a very high level. The theory says that investors value gains and losses differently, placing more weight on profits versus losses. That is people are more averse to making losses than gaining. It is said that for every rupee lost, an investor feels double the pain than for a rupee gained. This is more the case when the capital is irreplaceable.

History is replete with families who were once mega-rich but over generations have not been able to compound their wealth. A strong mix of strategies with defined risk management can help protect and generate wealth over very long periods of time.

This post first appeared on Moneycontrol.