Last Updated on February 12, 2022 at 6:20 pm
We all invest with the hope of having enough money for our future needs. This is true for even those who claim they do not have a goal – they just don’t know it yet. A good amount of equity exposure is important to beat inflation for long-term (10Y+) goals. However, many people make the mistake of assuming such an exposure will remain in the portfolio right until they need the money. In this post, we discuss why it is important, no vital, to reduce equity allocation in a portfolio (pull out) well before we actually need the money.
Yesterday, I had pointed out Stop your MF SIPs and start buying MF units! I only meant stop your SIPs and buy them manually each month on any d*&*^ day. I did not imply timing the market (although one can). One of the main reasons I said stops SIPs is because it makes understand the need for making active changes in asset allocation (provided you understand what that is!) as shown in this post. Simply starting your sips and hoping everything will turn out okay will not work.
Resolve is a series of steps on investing and portfolio management. In the first step, we considered how to quickly select equity mutual funds and build a diversified (equity) portfolio. As a second step, we discussed how to quickly decide if I should stay invested in a mutual fund or exit it. In the third step, we considered goal based risk management (in three parts, this is the third).
Step 3A: We recognised the need for systematic risk reduction. We need a clear goal. A clear date when we need the money and a clear target corpus: How to reduce risk in an investment portfolio
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Step 3B: As a follow-up, I presented some results to prove that this systematic risk reduction need not depend on any market signals. So we do not need to time the market in order to reduce risk.
Step 3C: In this part, using the same example, I explain why we need to reduce equity allocation in a portfolio well before we need the money. Since this is a video description, I explain all three steps (A,B, C) for clarity.
How to reduce risk in an investment portfolio by a simple step-wise reduction in equity
A note about portfolio drawdown
Drawdown refers to the extent by which a portfolio falls from its maximum.
Notice the drawdown shows the dip in the portfolio, -30% in this case. Now such drawdowns can occur more than once as shown below.
The max fall is the max drawdown = -9% in the above picture. So we get the max drawdown from each of the return sequences considered for both the constant equity and decreasing equity method and is shown below.
Notice that the decreasing equity method reduced risk by at least 50% compared to the constant equity method.
Summary
- A simple step-wise reduction* in equity (as shown below), no matter what the return sequence is, gets the job done with much lower risk.
- It also keeps the investor calmer!
* Equity can be further reduced if the portfolio is well above the target portfolio earlier than the goal deadline.
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