Why we need to gradually pull out of equity investments well before we need the money!

Published: July 8, 2018 at 9:40 am

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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

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.

photo by subtzi photography

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.

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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!

RR 3 - How to reduce risk in an investment portfolio

* Equity can be further reduced if the portfolio is well above the target portfolio earlier than the goal deadline.

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About the Author

M Pattabiraman author of freefincal.comM. 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 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, TamilNadu Investors Association etc. For speaking engagements write to pattu [at] freefincal [dot] com

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4 Comments

  1. Dear Sir
    what one should do when we see a very decent move in returns in absolute term say 15% in avery short span of time say 6-8 months and market is also making his new pick.

  2. The analysis is great, but if we change the asset allocation every year then the taxation arised on debt may affect the portfolio.. What is your say on this?

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