Last Updated on May 28, 2021 at 10:59 am
A viewer on YouTube wants to know which equity fund should one use for an 8-9 year SIP. She/he had also listed three funds to choose from. Their names are not important here. This type of question is perhaps the most common among those invested or interested in mutual funds. Unfortunately, this question is wrong.
Meaning there is no chance of finding a suitable answer. Pointing this out can be equally frustrating to both the person who asked the question and the person trying to answer it holistically.
The most common mistake in personal finance is putting products before the process. Even passive fund fans with an obsession over costs make this mistake. Yes, costs matter. Product selection matter but not before getting the process right.
Although not explicitly specified, it would be reasonably safe to assume the worst: the person has a need 8-9 years away and wants to start a SIP in an equity mutual fund for this. And what is wrong with this, you ask? Everything!
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We tested 209 9-year periods from Jan 1995 to May 2021. A 100% equity portfolio would have suffered a maximum fall (loss) of 60% and a median fall of 44% (the median is the value that divided the distribution into two). Encountering at least one crash in a nine-year period is likely, and even half of the highest loss encountered, about 30%, would be hard to handle emotionally and recover.
Worse than the loss in value is the loss the time. The longest an 100% equity portfolio was in “red” or below a previous maximum continuously for 40 months, and the median time was 17 months. So an investor has to be mentally prepared for about two years of continuous loss. Will there be enough time to recover? No one knows.
Regular readers of freefincal might get annoyed with these examples because they would say, “would invest in 100% equity and that too for a nine-year goal?”. The answer, lots of people. But let us leave them to their fate and consider some asset allocations.
Consider 50% equity and 50% steady fixed income like a liquid fund. The max loss encountered is 32% (a bit higher than half of 60%), the median loss 17%, the max time underwater is 27 months and the median time 10 months. This is still too risky for most investors. Even those who are theoretically brave enough to choose this cannot hold onto 50% equity for more than 4-5 years. After that, the risk of loss becomes even higher.
So what should be the asset allocation for a nine-year goal? I can tell you backtests results for 25% equity and 75% debt: 12% max loss and 5% median loss; 16 months max underwater and three months median underwater. However, is this the right asset allocation for you?
We can take hours and hours of risk tolerance questionnaires, but no one knows how much risk we can tolerate. Backtests help us set the right expectation, but they are only a rough guideline.
Let us assume you decide that about 30% equity is acceptable risk vs reward odds for you. How long will you hold this 30% for? This depends on the severity of the goal. If the goal is critical, then one should reduce the equity exposure well in advance and not wait for the last couple of years as many “advisers” recommend.
This means such a variable asset allocation should be used to set portfolio returns and how they would vary year after year in the planning process (actual variations would be higher!). For example a 10% return expectation and a 7% return expectation from debt means, the portfolio return with 30% equity is (30% x 10%) + (70% x 7%) = 8% (approx) with only 3% contribution from the equity component.
When the asset allocation varies, the portfolio return will vary too, and this should be factored in from day one; else, there would be a shortfall in the amount invested. Then one will have to keep in mind the portfolio should be rebalanced keep an eye on the target corpus (which should be determined first) all the time.
After all these steps, one can worry about what kind of equity funds one should use for this kind of goal. A Nifty or index fund will do. If you do not mind the extra cost, you can use an aggressive hybrid fund or balanced advantage or dynamic asset allocation fund to reduce the risk further. See Handpicked List of Mutual Funds Apr-Jun 2021 (PlumbLine) for recommendations.
If we are in a hurry to get fund recommendations without getting the right risk expectations, the right return expectations, the target corpus and the investment amount in place, then it is pretty much leaving the fate of our money to luck. We can do so much better. If you wish to get started the right way, consider watching Basics of portfolio construction: A seminar for beginners.
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