Last Updated on February 12, 2022 at 6:25 pm
Often, It is only when we see a big drop in the stock market do we recognise the need to worry about risk and how to manage it. What if a market crash wipes all the returns I have got so far? What if there is not enough time to recover before I need to withdraw for my goal? These are some practical questions and I would like to consider practical answers for these in a series of posts, starting with this one: How do I reduce risk in an investment portfolio – part 1: the basics.
Update: The results shown in this study are now fully incorporated into our robo advisory tool.
I have written about this in some detail: Simple Steps to De-risk Your Investment Portfolio and How can a 400% profit result only in 8% return?! Hodling to the moon Risk! and Want to be financially free? Do not count on frugality! Worry about sequence of returns risk! I would like to test the efficiency of the methods mentioned in these posts with real market data. Instead of taking only the annual returns to form a sequence of equity returns, I will be using the rolling returns calculators, particularly the data presented in this post: Sensex Charts 35 year returns analysis – stock market returns vs risk distribution to create rolling sequence of returns from one business day to the next.
This would be my own version of “big data”. So from just on the sequence we can scale up to 1000s of return sequences and back-test the efficiency of different portfolio management strategies. I shall explain how exactly this is created in the second part. In this post, which is part of re-assemble – a series on the basics of money management, we will consider some examples.
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I am surprised at how many people have blind faith in equity. Even if they get sustained poor returns, many are confident that things will turn around just before the need the money. This is atrociously stupid. Please recognise that the money in the stock market is of no use! It is real money only when you withdraw!
Let us consider a goal that is 15 years away. The current cost of that goal is 10 lakh. Assuming 10% yearly inflation, the future cost is shown below (blue dots). If we start investing for this in a mix of equity and debt (fixed income), the corpus assuming same returns (10% from equity and 7% from debt – both post-tax), the total corpus will be shown as below. The investment is assumed to increase 5% each year.
Naturally, the aim should be for corpus (red line) to hit the target (blue line) on or before the end of the 15Y period. We start from 0, so it ends at 14. When the returns are fixed, you get a nice smooth corpus growth. Returns in real life fluctuate wildly as you will see below. This is known as sequence of returns.
Now, there are two way to invest in equity and debt. Use the same asset allocation for each year. Say 60% equity and 40% debt. We will refer to this as constant equity allocation
Or we can reduce equity gradually as we approach the goal. I prefer a step-wise decrease (on paper at least) and this is the approach recommended in the Freefincal Robo Advisory Software Template. We will refer to this as the reducing equity allocation.
Portfolio Risk reduction for Return sequence 1 (RS1)
Assuming a 7% fixed return from debt year-on year, this is a real Sensex return sequence from the past:
-18%, -12%, 27%, -27%, 52%, -13%, -22%, -3%, 69%, 23%, 43%, 54%, 35%, -55%, 86%. Each of these is a return after one of year of investing. So 15 annual returns for 15 years of investing.
RS1: Constant Equity method
The blue dots represent the increase in targe corpus due to inflation. The red dots show the growth of the actual corpus. No rebalancing is done. That is, although we will invest 60% of a sum in equity and 40% in debt, we will not worry about the asset allocation of the corpus.Notice how dangerous the constant equity approach is.
What if we reset the asset allocation to 60% equity and 40% fixed income at the end of each year? This is known as rebalancing. For those are new to this idea, see: How to Rebalance Your Investment Portfolio
Notice that the risk is reduced, but only by a small amount.
RS1: Decreasing Equity method
If I decrease the investment to equity but do not do anything to the value of the equity portfolio, that is I do not rebalance, then there is really no benefit.
However, I also rebalance as per the reducing equity schedule as shown above, we get a nice smooth approach to the target corpus well before the target date.
What is the message here? (1) Employ a reducing equity schedule and religiously stick to it. This is a simple way to reduce the sequence of returns risk. (2) Do not get married with a SIP. Invest manually on your own. It will take 30 seconds of your time. This will get you into portfolio management mode. You can invest or less each month as per the set schedule or change mid-way.
Hang on, we just tried on return sequence. Let us try some more. In the second part of this post, I will post the results of tens of hundreds of sequences. The following graphs are for food for thought. Please note that in the decreasing equity method, the unrebalanced graph is not of much use. So focus on the green dots alone.
Portfolio Risk reduction for Return sequence 2 (RS2)
60%, 4%, -1%, 10%, -20%, 40%, -19%, -3%, -15%, 81%, 29%, 77%, 38%, 17%, -13%, 16%
RS2: Constant Equity method
RS2: Decreasing Equity method
Portfolio Risk reduction for Return sequence 3 (RS3)
15%, -3%, -3%, 63%, -19%, -22%, -2%, 76%, 13%, 53%, 39%, 26%, -49%, 84%, 8%
RS3: Constant Equity method
RS3: Decreasing Equity method
Portfolio Risk reduction for Return sequence 4 (RS4)
-14%; -19%; 13%; -2%; -5%; 75%; -26%; -19%; -8%; 72%; 17%; 54%; 21%; 30%; -49%
RS4: Constant Equity method
RS4: Decreasing Equity method
Portfolio Risk reduction for Return sequence 5 (RS5)
24%; -21%; 68%; -16%; -17%; -3%; 63%; 16%; 45%; 48%; 46%; -52%; 76%; 15%; -20%
RS5: Constant Equity method
RS5: Decreasing Equity method
Portfolio Risk reduction for Return sequence 6 (RS6)
0%; -5%; 75%; -26%; -19%; -8%; 72%; 17%; 54%; 21%; 30%; -49%
106%; 6%; -3%
RS6: Constant Equity method
RS6: Decreasing Equity method
Impressions
For the six different Sensex return sequences considered, the decreasing equity method + annual rebalancing works even if the return after the first 5-6 years is negative! This means you need to take the decreasing equity contribution into the investment amount calculation from day one. The robo advisory template does this for you.
Re-Assemble: money management basics for young earners
Re-assemble is a series focussing on the basics of money management for young earners.
Step 1: Listing your goals dreams and nightmares
Step 2: Lay the Foundations to Get Rich creating an emergency fund
Step 3: How to buy Term Life Insurance
Step 4: How to choose a suitable health insurance policy
* Apollo Munich Optima Restore Benefit vs Max Bupa Re-fill Benefit
* Star Health Comprehensive Insurance vs Religare Care Comprehensive Insurance
* Building a health insurance comparison chart + Cigna TTK vs Royal Sundaram Health Policies
* How to buy a Super Top-up Health Insurance policy
* How I selected a health insurance policy
* Why we all need a corpus for medical expenses and how to build it
Step 5: How to select a credit card for maximum benefit
Step 6: How to track monthly expenses and manage them efficiently
Step 7: How to close your loans and live debt-free
Step 8: How to buy a personal accident insurance policy
Step 9: Are you ready to let go and let your money grow?
Step 10: Investment planning case study 1: How to create an investment plan
Step 11: Case study 2: Retirement planning for 27-year old Amar
Step 12: Three Key Factors that decide how we achieve our financial goals
Step 13: How to start investing in equity?
Step 14: What should be my first mutual fund?
Step 15: How to select an equity mutual fund in 30 minutes!
Step 16: How to buy a house with a home loan: Tips to maximize benefits
Step 17: How to reduce risk in an investment portfolio (this post)
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