A reader says, “Can I manage with only 20% equity MFs for retirement? I am scared of more exposure to the stock market. I have about 24 years to retire.”
The main aim of investing for long-term goals is to keep pace with inflation. That is, the purchasing power of the future corpus should be at least the same as today. See Inflation at Work: Rs. 1000 in 1981 Worth Only Rs. 52 Today!
The most common way to accomplish this is to (initially) use 50-60% equity when the goal is at least 15 years or more. For retirement planning illustrations, see: Can I retire by age 55? Retirement Planning Case Study. And, Retirement plan review: Am I on track to retire by 50?
This is because most investors do not have enough to invest and cannot afford lesser equity in the portfolio. Naturally, if the investor had a lot of money to spare, the asset allocation could even be 100% fixed income (zero equity). See: Can I Plan My Retirement With Recurring Deposits and Fixed Deposits?
Also see: How I achieved financial independence without mutual funds or stocks or How to invest without mutual funds.
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Assuming long-term equity returns (after tax) are higher than fixed-income returns (after tax), some risk is necessary to boost the possibility of higher returns. See: Why should I invest in equity mutual funds when there is no guarantee of returns?
Let us do a ballpark retirement calculation.
| Anticipated post-retirement interest rate (remember, this is when you retire. So expect less!) | 5.00% |
| Current expenses per month (annual/12) | 30000 |
| No of years you expect to work (We shall assume retirement is at 55) | 24 |
| Expected inflation throughout your lifetime (this includes lifestyle creep as well) | 6.00% |
| Estimated years in retirement (we should plan until age 90, just in case!) | 35 |
| The average rate of interest expected from all asset classes (see explanation below) | 8.50% |
| The annual increase in the monthly investment you can manage | 5.00% |
| Amount invested so far. We assume this to be zero for simplicity). For a more elaborate calculation using the future value of current investments and multiple post-retirement income sources, use the freefincal robo advisory tool. | – |
| Monthly investment needed as % of current expenses | 123.89% |
Before we look at the final result, how did we arrive at this 8.5% expected return?
Suppose we expect 10% from equity (post-tax). This is likely to be an overestimate at the time of retirement, but there are only so many shocks we can handle simultaneously!
Suppose we expect 7% post-tax from fixed income. Again, this is possibly overestimated by the time the reader turns 55.
The expected return for an asset allocation of 50% equity and 50% fixed income is:
(10% x 50%) + (7% x 50%) = 8.5%
So even with as much as 50% equity in the portfolio, the investment amount required is 124% of the current monthly expenses! And this should increase by 5% a year. How many can pull this off?
Guess what happens when the equity allocation is reduced to 20%!
(10% x 20%) + (7% x 80%) = 7.6%
Monthly investment needed as % of current expenses = 166%.
So, to answer the reader’s question, I don’t think you can manage with 20% equity, not when you have so much time left for retirement. However, that is good enough for a start. You can consider increasing the equity allocation by 5-6% each year over the next 5-6 years.
So what should those afraid of equity investing do?
The risks a person is willing to take, and the risks a person should take are often different. With small steps, we can find common ground between the two.
- Focus on the bigger risk: The daily risk to your capital while investing in equity is significant. Although there are no guarantees, this risk is reasonable and manageable. See: Why should I invest in equity mutual funds when there is no guarantee of returns? The bigger risk is not being able to handle your expenses and inflation in those expenses after retirement. This is not a manageable risk. If you do not have enough money, you must duck for cover and “adjust”! See: Why have we not seen a retirement crisis in India?
- Be emotional about the bigger, unmanageable risk: This is how I could withstand five years of zero returns from equity mutual funds from 2008 to 2013. See 15 years of mutual fund investing: My Journey and lessons learned.
- Start small and slow: Increase the equity allocation gradually, as mentioned above. There is nothing that human beings can’t get used to. Slowly, the volatility will become second nature to you. Thankfully, you have time to do this.
- Review your portfolio each year: I am not talking about gains and returns. Focus on your goals. Find out your target amounts. Check where you are on this journey. Find out your current asset allocation. Find out what your target allocation is and plan for necessary action.
Take baby steps, and soon, you will dash to your goals briskly!