How to reduce risk in an investment portfolio

Published: April 7, 2018 at 10:55 am

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.

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥

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

portfolio-risk-reduction method one

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


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)

Do share this article with your friends using the buttons below.

🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
Follow Freefincal on Google News
Follow Freefincal on Google News
Subscribe to the freefincal Youtube Channel. Subscribe button courtesy: Vecteezy.
Subscribe to the freefincal Youtube Channel.
Follow freefincal on WhatsApp Channel
Follow freefincal on WhatsApp
Podcast: Let's Get RICH With PATTU! Every single Indian CAN grow their wealth! 
Listen to the Lets Get Rich with Pattu Podcast
Listen to the Let's Get Rich with Pattu Podcast
You can watch podcast episodes on the OfSpin Media Friends YouTube Channel.
Lets Get RICH With PATTU podcast on YouTube
Let's Get RICH With PATTU podcast on YouTube.
🔥Now Watch Let's Get Rich With Pattu தமிழில் (in Tamil)! 🔥
  • Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
  • Have a question? Subscribe to our newsletter using the form below.
  • Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!

About The Author

Pattabiraman editor freefincalDr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free!  One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course!  Increase your income by getting people to pay for your skills! More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!   
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Both boy and girl version covers of Chinchu gets a superpower
Both the boy and girl-version covers of "Chinchu Gets a superpower".
Most investor problems can be traced to a lack of informed decision-making. We made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So, in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it, as well as teaching him several key ideas of decision-making and money management, is the narrative. What readers say!
Feedback from a young reader after reading Chinchu gets a Superpower (small version)
Feedback from a young reader after reading Chinchu gets a Superpower!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.
Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)