NPS is the iPhone of retirement products

The National Pension System, more popularly known by the abbreviation NPS, is a retirement investment product. The NPS is somewhat like a retirement product that Apple, the American tech company that makes iPhones, would design.

1. NPS gives you controls, but they are so limiting that savvy investors would feel they don’t have much of a control.
2. NPS is opinionated, and makes many decisions for you. When is the earliest you can retire? The system will tell you. How should you use your retirement corpus? The system will tell you.
3. NPS is limited and doesn’t have some options that have been available outside the NPS for several years. Want to invest in an equity index? Not possible. Want to invest in global equity? You can’t do that. Just make peace with what the system gives you.

Quite a few technically savvy people use Apple products too, but it’s not hard to argue that Apple products are designed with “the masses” as their primary user base. NPS is also the same. It’s a retirement product for people who are not money-savvy.

How to think about portfolio rebalancing?

Portfolio rebalancing is an essential portfolio maintenance operation (learn more about rebalancing).

I hear that many investors don’t regularly rebalance their portfolios because rebalancing means booking profits—and booking profits means paying taxes. Rebalancing is also counterintuitive because rebalancing is trimming down exposure to assets that have done well in the recent past and increasing exposure to assets that have not done as well. No one wants to sell their winners to buy more of their losers.

I think such a hesitation to rebalance stems from a lack of understanding. Rather than looking at the portfolio as one unit, the investor likely looks at different asset classes in the portfolio as independent assets.

Think of an investment portfolio with 3 different asset classes. This could be equity + bonds + gold, but it doesn’t really matter which specific assets. A portfolio that contains these assets is like a stool with 3 legs. When one leg grows too tall or shrinks too short, the stool loses balance and collapses. When one asset in the portfolio has an outsized growth or a big fall, your portfolio loses balance.

“Stool” by an unidentified maker from rawpixel.com; licensed under CC0

But stools are a poor analogy. Every stool needs legs that are of equal height, but portfolio assets are often mixed in different proportions. If you don’t like to visualise your portfolio assets as legs of a stool, maybe think of the portfolio as a primitive aeroplane that is balanced using weights attached to its sides. What happens when one weight becomes too heavy or too light? The whole plane loses balance and can fall down. Regularly assessing and readjusting the weights to keep them in the right proportion is crucial to keep the plane stable and flying.

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Using such a mental model helps in 2 ways:

1. It enables us to see the portfolio as one entity rather than as a collection of independent entities.
2. It makes rebalancing less painful, and possibly even satisfying, because your focus is shifted from individual assets or tax bill over to the stability of your portfolio.

Both of these can contribute positively to investing success.

There is no such thing called ‘overdiversification’

Some phrases annoy me whenever I hear them. ‘Rat race’ is one: it’s a disrespectful, polasing name invented by people who just want to sell their stuff or idea. Regular people need not repeat that slur.

‘Hard earned money’ is another: money deserves just as much respect irrespective of how easy a time you had earning it.

The most recent in that list is ‘overdiversification’. Hearing it annoys me because overdiversification is not a real thing.

Let’s say you hold N assets in your portfolio. Adding another asset that is positively correlated with any other existing asset does not yield much of a benefit. Example: You already hold UTI Nifty 50 index fund. Adding ICICI Nifty 50 index or a large cap equity fund is not going to give you much of a diversification. By adding this fund you are not overdivesifying, but you are just adding clutter. Portfolio clutter indicates a real problem, but that problem is not “too much diversification”. Portfolio clutter is a different problem.

Let’s say you hold an Indian equity mutual fund (it doesn’t matter which category). Credit risk debt funds have low correlation with equity, so adding it will give you diversification benefits. But most retail investors are better off without such credit risk in their portfolio. This diversification doesn’t help because it’s just a bad asset to hold. The drawbacks of such a risky asset easily overshadow the benefits. This is just poor asset selection rather than “too much diversification”. (Or you can call it “diworsification” if you feel cute.)

Overdiversification is just the wrong name people use to describe one of these unrelated problems.

If you think this post is making a pedantic argument, you’re right. Cribbing about the choice of words people use is indeed pedantic. But pedantry has its uses, too. Calling things by their correct names is crucial to avoid misunderstanding. I’ll let you decide whether or not to correct someone using the word overdiversification, but you should know that people often use this word to describe very different problems.