Simple Steps to De-risk Your Investment Portfolio

Risk management is the key to investing in volatile instruments like equity (or gold). De-risking refers to a process of containing losses. This typically is achieved by targeting a better risk-adjusted return instead of a 'better return'.De-risking can passive or active. Here are some simple steps to de-risk your investment portfolio

Cautionary note: A mutual fund SIP does not minimise risk. It is being sold as a means to 'build wealth' - all one needs to do is to run the SIP through market ups and downs. To say the least, this is silly! Read more: What you need to know before starting a mutual fund SIP

1. Start investing early 

Boring as it may sound, there is no better way to lower risk than beginning early. The more time you have in your hands, the more time you will have to recover. So start investing asap.

In the simple compound interest equation,

Value = investment x (1+ return) duration,

Duration and quantum of investment (not returns) are responsible wealth creation. So ensure you maximise both.

2. Expect less 

This is the most important step in de-risking. The lower your return expectations, the lower the risk.

Investors who want a minimum of 20% return from their equity portfolios will have to take a lot more risk than investors who only want 10%.

The long term return from Indian equity markets  is not the 15% that everyone says it is. That number is heavily influenced by the Harshad Mehta scandal.  If no such scandal occurs, the long-term return drops to 10% (see how here).

So we need to be realistic in our expectations. This is vital in keeping us calm.

Remember we pose the biggest risk to our folios! So the calmer we are, safer the folio.

Most investors become jittery because they fail to understand how equities ‘compound’. We expect 10% long-term returns from equities. This means one should not expect 10% year after year in investment.

Some years will be good, some excellent and some terrible. What you get is the net effect:

Value = investment x [(1+ good return) x (1+ terrible return) x (1+ excellent return) x…… ]

So the key is to stay the course.

3. Asset allocation

Naturally, one cannot afford to be in 100% equity. The terrible return would then negate the effect of the good returns, and one would be left with nothing.

The only logical solution is to limit the fluctuations in the portfolio returns due to swings in equity return.

Therefore, one must include safer assets like (fixede income instruments) bonds to reduce the overall risk to the folio.

Here safety  refers to the poor (small) correlation between the movements of equity markets with debt markets. Fluctuations in one will generally not affect the other too much.

How much should the equity:debt proportion be, depends entirely on the goal duration and nature. Here is an example

risk-1
Returns indicated are before taxes!

4 Choose wisely

Conservative asset allocation and return expectations are important but amount to nothing if the right kind of investments are not chosen.

The simplest and most important measure of risk investors must understand is the standard deviation – a measure of how much a set of returns deviation from their average.

Lower the standard deviation, lower the risk.

The first step is to choose the right category of instruments. Here is a step-by-step guide to help you do that.

As a general thumb rule, lower the investment duration, lower should be the standard deviation of the instrument.

For example, choosing an equity-oriented balanced fund for a 5-year investment duration is madness.

Read more: Equity investing: How to define ‘long-term’ and ‘short-term’

 5 Diversify

Asset allocation represents diversification across asset allocation. One should also diversify within an asset class. For example, equity holdings should be spread across market cap, sectors, nature of stocks and geography.

Diversification is the second most important step (expecting less is the first). Use this tool to find out how diversified your equity mutual funds are.

A well-diversified portfolio with reasonable expectations will significantly reduce downside risk.

These are mandatory requirements of any investor.

Read more: How to build a diversified mutual fund portfolio

Minimalist Portfolio Ideas for Young Earners

The above-mentioned ideas represent passive de-risking. For a goal that is say 20 years away, passive de-risking is all that is required for the first few years. Active de-risking becomes necessary after that.

6 Periodic Review

It is essential to monitor the performance of instruments and take corrective action. However, this has to be done with meaning benchmarks.

How to Review Your Mutual Fund SIPs

How to review a mutual fund portfolio

 7 Rebalancing

One can do a little better. You start with some asset allocation in mind. With time gains or losses in individual instruments will skew the allocation and it will begin to deviate.

For example, a 60:40 equity:debt investments started a year ago could easily be 65:35 or 70:30 because of the upward swing in the equity market.

If this skewed allocation is reset to 60:40 by pushing some amount from the equity folio to the debt folio, the gains made in a volatile asset (equity) are shifted to a less volatile asset (debt) thereby preserving them.

This is known as rebalancing. There are several ways to do this. Learn more here.

Check out this volatility simulator to understand how rebalancing can be used to de-risk a folio and enhance gains.

Rebalancing requires no special know-how. All it requires is discipline. The discipline to shift capital from a well-performing asset class to a safer one!

Rebalancing is not  profit booking.

Read more: How to Rebalance Your Investment Portfolio

 8 Tactical asset allocation

When markets rise, they will soon become overvalued. Stocks will be priced higher than they are worth and one can expect prices to fall … sooner or later.

A simple indicator market valuation is the P/E ratio or the price/earnings ratio. Another is the 200-day daily moving average.

Tactical asset allocation refers to the change in asset allocation of the portfolio according to market conditions.

Tactical asset allocation can be implemented many ways. For example,

1) when PE value is high, say > 22, stop investments, accumulate them and invest when the PE value becomes lower, say < 18. Read more about this here

2) when PE is high, say >22, stop investment and shift to debt. Move back and resume investment when PE value become lower. Read more about this here

This requires even greater discipline than rebalancing and extraordinary level-headedness.  For example, the markets could increase after we pull out. If we are ones who tend to regret and lose focus, this is not for us.

Tactical asset allocation is not  profit booking.

Note: Tactical asset allocation is timing the market. Personally, I do not indulge in this.

Read more: 

9 Quit while ahead

Equity holdings should be decreased gradually as the goal approaches. Three – five  years before the deadline, the portfolio should be in pure low volatile debt instruments with no equity.

This means the last few years, the returns would be much smaller than your overall expectations. A simple way to account for this while planning for goals is to reduce the duration by two years.

If your child’s education goal is 14 years away, assume it is 12 years away. Therefore, few years years before the actual goal date, much of the corpus is accumulated, and can be kept away safely.

In the case of retirement, some amount of equity can remain, depending on the health of the portfolio.

There are no hard and fast rules here. If say, 6-7 years before the goal the returns are very good, then equity exposure can reduced to zero in one shot. On the other hand, if returns are small even after years of equity investing, then one will have to exit (with or without regret)

~~~~~~~~~

With these simple guidelines –most of which is commonsense – one can de-risk the portfolio effectively, remain calm and focused.

First published May 28, 2014. Republished after a rewrite.

Install Financial Freedom App! (Google Play Store)

Install Freefincal Retirement Planner App! (Google Play Store)

book-footer

Buy our New Book!

You Can Be Rich With Goal-based Investing A book by  P V Subramanyam (subramoney.com) & M Pattabiraman. Hard bound. Price: Rs. 399/- and Kindle Rs. 349/-. Read more about the book and pre-order now!
Practical advice + calculators for you to develop personalised investment solutions

Thank you for reading. You may also like

About Freefincal

Freefincal has open-source, comprehensive Excel spreadsheets, tools, analysis and unbiased, conflict of interest-free commentary on different aspects of personal finance and investing. If you find the content useful, please consider supporting us by (1) sharing our articles and (2) disabling ad-blockers for our site if you are using one. We do not accept sponsored posts, links or guest posts request from content writers and agencies.

Blog Comment Policy

Your thoughts are vital to the health of this blog and are the driving force behind the analysis and calculators that you see here. We welcome criticism and differing opinions. I will do my very best to respond to all comments asap. Please do not include hyperlinks or email ids in the comment body. Such comments will be moderated and I reserve the right to delete  the entire comment or remove the links before approving them.

32 thoughts on “Simple Steps to De-risk Your Investment Portfolio

  1. ashalanshu

    With these simple guidelines –most of which is commonsense – one can de-risk the portfolio effectively, remain calm and focused, paying little or no attention to the current state of the market.

    But the most common thing is - Lack of common sense or application of common sense.

    Thanks

    Ashal

    Reply
  2. ashalanshu

    With these simple guidelines –most of which is commonsense – one can de-risk the portfolio effectively, remain calm and focused, paying little or no attention to the current state of the market.

    But the most common thing is - Lack of common sense or application of common sense.

    Thanks

    Ashal

    Reply
  3. Abhijit

    Regarding portfolio rebalancing, for an example, I have decided my debt:equity ratio should be 40:60 and I decide to rebalance the portfolio yearly. Now, the equities tank in the first year and my new ratio is 50:50. So, I should take out some amount from the debt portion and invest the same to equities to bring back the ratio to 40:60.
    My question is should this be done at one go? Or should I setup an STP to move money from Debt to Equity?
    Also please suggest on how one needs to proceed when conditions are reversed (equities zoom and there is need to take out some money from equities and invest to debt).

    Reply
    1. pattu

      Good question! The thing about rebalancing is, it requires the maturity to pull out of a well performing asset and invest in a poorly performing asset! For both scenarios you suggest, it can be done in one go. No STP required.

      Reply
      1. Abhijit

        Thanks Sir. Ideally, what should be the duration between two portfolio rebalancings? Eg., Monthly, Quarterly, Half Yearly, Yearly or any other duration?

        Reply
  4. Abhijit

    Regarding portfolio rebalancing, for an example, I have decided my debt:equity ratio should be 40:60 and I decide to rebalance the portfolio yearly. Now, the equities tank in the first year and my new ratio is 50:50. So, I should take out some amount from the debt portion and invest the same to equities to bring back the ratio to 40:60.
    My question is should this be done at one go? Or should I setup an STP to move money from Debt to Equity?
    Also please suggest on how one needs to proceed when conditions are reversed (equities zoom and there is need to take out some money from equities and invest to debt).

    Reply
    1. pattu

      Good question! The thing about rebalancing is, it requires the maturity to pull out of a well performing asset and invest in a poorly performing asset! For both scenarios you suggest, it can be done in one go. No STP required.

      Reply
      1. Abhijit

        Thanks Sir. Ideally, what should be the duration between two portfolio rebalancings? Eg., Monthly, Quarterly, Half Yearly, Yearly or any other duration?

        Reply
  5. Ashok

    Thank you Pattu.

    Is there a reason why you consider NSE's PE ratios over BSE's?

    While the 'Nifty PE ~ 20.2 and CNX 500 PE ~ 20.7', the PE of BSE Sensex is 17.93 and BSE 500 is 17.24. The differences are quite significant between the PE values of BSE and NSE.

    Which one is more relevant for a mutual fund investor?

    Regards,
    Ashok

    Reply
    1. pattu

      Good question. I think one should look at the benchmark indices only and take a call. I just looked at some reasonably broad based indices for illustration.

      Reply
  6. Ashok

    Thank you Pattu.

    Is there a reason why you consider NSE's PE ratios over BSE's?

    While the 'Nifty PE ~ 20.2 and CNX 500 PE ~ 20.7', the PE of BSE Sensex is 17.93 and BSE 500 is 17.24. The differences are quite significant between the PE values of BSE and NSE.

    Which one is more relevant for a mutual fund investor?

    Regards,
    Ashok

    Reply
    1. pattu

      Good question. I think one should look at the benchmark indices only and take a call. I just looked at some reasonably broad based indices for illustration.

      Reply
  7. sandeep

    Hi Pattu- Is there a reason you did not include real estate investment as part of your asset allocation/diversification strategy? I havent read all your posts but from the ones I did read I came away with an impression that you dont typically mention real estate investments. My apologies if you have mentioned it in some places and I didnt read it. I think real estate is still one of the best long term investments in India (as part of a diversified portfolio of course). Given the high inflation in India that is one investment which is likely to keep pace (both as a rental property as well as for capital appreciation).

    Reply
    1. pattu

      Hi Sandeep,
      In RE, there seems to be more supply than demand. Please go and check how many of the multi-storied apartment complexes are actually rented out? Rent appreciates at 5% per year. So it can hardly keep pace with inflation and that is assuming you will get someone to stay. As for property appreciation, perhaps it will, but if it does not and falls for some reason it will take a while to get back unlike equity.
      Unless you are super-rich I don't think the retail investor can construct a diversified folio with RE in it.
      They say past performance does not guarantee future returns. This fits RE better that it does equity!

      Reply
  8. sandeep

    Hi Pattu- Is there a reason you did not include real estate investment as part of your asset allocation/diversification strategy? I havent read all your posts but from the ones I did read I came away with an impression that you dont typically mention real estate investments. My apologies if you have mentioned it in some places and I didnt read it. I think real estate is still one of the best long term investments in India (as part of a diversified portfolio of course). Given the high inflation in India that is one investment which is likely to keep pace (both as a rental property as well as for capital appreciation).

    Reply
    1. pattu

      Hi Sandeep,
      In RE, there seems to be more supply than demand. Please go and check how many of the multi-storied apartment complexes are actually rented out? Rent appreciates at 5% per year. So it can hardly keep pace with inflation and that is assuming you will get someone to stay. As for property appreciation, perhaps it will, but if it does not and falls for some reason it will take a while to get back unlike equity.
      Unless you are super-rich I don't think the retail investor can construct a diversified folio with RE in it.
      They say past performance does not guarantee future returns. This fits RE better that it does equity!

      Reply
  9. Viren Phansalkar

    Not only this post is informative, the links embedded in it are useful too... Thank you Pattu

    Reply
  10. Viren Phansalkar

    Not only this post is informative, the links embedded in it are useful too... Thank you Pattu

    Reply
  11. Deepak

    Dear Pattu,

    A regular reader but commenting first time... Quite liked the tactical allocation part - Subra has also been talking of position trading ( am not linking the two) - just that one of the tenets of value investing/ or dare I say good investing is low activity - I think once you get the basic house keeping done, some of these improve the robustness of portfolio returns - you never know when you might hit a long down patch in the markets....

    Reply
  12. Deepak

    Dear Pattu,

    A regular reader but commenting first time... Quite liked the tactical allocation part - Subra has also been talking of position trading ( am not linking the two) - just that one of the tenets of value investing/ or dare I say good investing is low activity - I think once you get the basic house keeping done, some of these improve the robustness of portfolio returns - you never know when you might hit a long down patch in the markets....

    Reply
  13. Senthil

    Thanks Pattu for the excellent article .. if 10% is the expectation, then for senior citizens they have many options like corporate fixed deposits from FAAA companies who provide 9% return and SCSS for 8.4% .. Also for salaried class they can leverage PPF which provides tax free 8.1% ..

    Reply
  14. Austin Joseph

    Hello Pattu , I had this query for long term investment 8-10 plus years staying invested on Ultra Short Term Debt is a good idea ? The critera to select UST should be higher returns for 3-5 years or low standard deviation ?

    Reply

Do let us know what you think about the article