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.
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)
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.
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