How to reduce risk in an investment portfolio

Published: April 7, 2018 at 10:55 am

Last Updated on

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.

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.

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. The question is, are there any sequence of returns in the past where it has failed? We will consider that in the second part.

Over the course of this summer, I will gradually expand this analysis to early retirement portfolio as well.

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 if you found this useful
Share your thoughts on this topic at the  Reddit freefincal_user_forum

Reach your financial goals like a pro! Join our 1600+ Facebook Group on Portfolio Management! You can now reduce fear, doubt and uncertainty while investing for your financial goals! Sign up for our lectures on goal-based portfolio management and join our exclusive Facebook Community. The 1st lecture is free!
Want to check if the market is overvalued or undervalued? Use our market valuation tool (will work with any index!) or you buy the new Tactical Buy/Sell timing tool!
About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. We operate in a non-profit manner. All revenue is used only for expenses and for the future growth of the site. Follow us on Google News Freefincal serves more than one million readers a year (2.5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any kind of paid articles, promotions or PR, satire or opinions without data. All opinions presented will only 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, seek the right answers and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now. It is also available in Kindle format.
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 low cost! Get it or gift it to a young earner

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, 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 199 (instant download)
Free android apps