The subtle tweak that can give you maximum return at minimum risk

Traditional wisdom says don’t put all your eggs in one basket. It restricts the damage to your financial well-being in case one asset class or instrument goes for a tailspin. For example, equities crashed by 39% during 2008-9. If you had a goal maturing that year and were depending largely on stock investments, it would have been a disaster.However, if you had spread your investments across equity, debt, cash and gold, the portfolio would have given an average return of 0.68% (see graphic). This is because of the stellar performance by gold (up 24%) and stable returns from debt and cash during that year. The situation reversed the next year, with equities rising 94% and all other asset classes giving lacklustre returns. Even so, the diversified portfolio managed to generate 27% returns that year.Not all investing stories have happy endings though. Some may think that diversification led to lower returns in 2009-10. Instead of earning 27% from an equally weighted portfolio they could have earned 94% from equities. But this is based on hindsight. In the real world, most equity investors would have panicked and withdrawn from the market in 2008-9, when equities had crashed by 39%. “Those who held on during the difficult periods of 2008-9 would have made money, but most would not have because genetically humans are risk averse and react to crisis situations,” says Kunal Bajaj, Founder and CEO, Clearfunds.Purpose of diversificationThe basic objective of diversification is to reduce risk. But can’t one do that by investing only in ultra-safe government schemes such as PPF, NSCs and RBI bonds? No, because investing in these instruments will reduce the overall returns significantly. “Investing 100% in debt options won’t help meet future needs. Investors should have some growthoriented assets such as equities to increase returns,” says Rahul Agarwal, Director, Wealth Discovery. Besides lower returns, the income from debt products attracts higher tax rates. “Interest is taxable for most debt instruments, so the post-tax return will be very low and won’t beat consumer inflation,” says Amol Joshi, Founder, PlanRupee Investment Services. Investors may have to forgo several of their financial goals if they follow this risk-free strategy.Though everyone would love to earn high returns without taking any risk, in real life one has to manage risk and return together. “What investors should aim is for decent returns with reasonable level of risk,” says Shailendra Kumar, CIO, Narnolia Financial Advisors. The best way to do this is by following a disciplined asset allocation strategy.A diversified portfolio can give decent returnsYear-wise returns from some asset classes have been quite volatile in the past 11 years. The diversified portfolio was more stable. 64895269 Figures are returns from the asset classes during the financial year. Negative returns marked in grey. Ideal asset allocation for youThough there are thumb rules, the asset allocation should be based on individual needs. Here are a few things to keep in mind when determining the asset allocation of your portfolio.Current asset allocation: As a first step, investors need to understand where they stand. Many aggressive investors, who claim that they have invested 100% in equities may not be aware of the real situation.“There is no investor who has put 100% in equities. People who say that usually mean that 100% of their liquid assets are in stocks,” says Bajaj. “Most people usually ignore investments like EPF, PPF, etc while calculating their asset allocation. If they consider all of them, their status can change from ‘aggressive’ to ‘moderate’,” says Melvin Joseph, Founder, Finvin Financial Planners.Everyone needs debt products: Though debt offers low returns, investors can’t ignore it altogether. This is because every investor’s first financial goal should be to create contingency corpus—a liquid corpus that can take care of 3-6 months’ expenses. A large portion of this needs to be in extremely liquid instruments such as bank FDs that can be broken immediately (you may need funds immediately in case of medical emergency, even if you have medical cover) and the remaining can be with liquid funds. Since these are debt products, the remaining portion only can be allocated to other asset classes.Your age: Age is a major influencer in deciding asset allocation. The ‘100 minus your age’ is the most commonly used thumb rule for equity allocation. It says that young investors should have higher equity allocation (eg investors with 25 and 35 years of age should have equity allocation of 75% and 65% respectively), while older people should have lower equity allocation. Young investors have smaller portfolios (Rs 1-2 lakh) so the absolute loss will not be as painful compared to a bigger portfolio (`40-50 lakh) of an older investor. Second, younger people have a longer investing horizon and can wait it out if the portfolio takes a tumble. Third, they usually don’t have high commitments like supporting a family, children’s education, etc and can afford to take higher risks.Willingness to take risk: Many youngsters are not ready to take higher risks. “The equity allocation is right when investors can take a 20-30% cut in a year without affecting their lifestyle or losing sleep,” says Bajaj. This willingness to take risk is the investor’s ‘risk appetite’. But this risk appetite is a double edged sword—some people believe they can take higher risk without understanding the implications. These aggressive investors get jumpy when their SIPs start generating losses. “Besides the risk appetite, we also have to consider the experience of equity investing when suggesting the asset allocation of an individual. For example, 50% equity allocation is fine for a 70-year-old veteran equity investor. But a first-time investor should not have more than 30% in stocks,” says Joseph.Ability to take risk: Investors also need to consider their ability to take risk. People with steady income streams can take higher risk with their investments because the market volatility won’t affect their lifestyle. This should be a critical consideration while allocating retirement corpus because the ability to take risk can vary with age. “Several investors get nervous close to retirement. Risk appetite or risk taking ability can also change due to health related issues. So qualitative factors like this also should be considered while fixing asset allocations,” says Joseph.Time period to goal: The time available for the goal is equally critical. The general rule is that invest more in equities if the time horizon is long and in debt if it is short. Stock market volatility comes down as the investment horizon increases. As a thumb rule, don’t put any money into equity if the holding period is less than three years. Increase the equity component if the holding period is more. Some experts say that if the goal is 10 years away, you should invest the entire corpus in equities.Goal level or individual level: Asset allocation should be primarily based on the time available for the goal. If the equity exposure is high, it should then take into account other parameters such as the investor’s age, risk appetite, risk taking ability. Suppose all the goals of a young investor are long term (8, 12 and 15 years). Even then, the entire allocation should not be to equities. “The investment portfolio, regardless of the time frame, should be balanced. Never put the entire money into equity just because all the goals are far off,” says Agarwal.This may contradict the general principle that equities generate the best returns in the long term. But this modification is needed to give investors peace of mind. “The purpose of balanced portfolio construction is not to get the highest returns, but to reach the goal comfortably,” says Joseph.Strategic changes in allocation: The asset allocation should not ignore market situations. “An asset class trading at elevated valuations will have higher risk compared to an asset class trading low,” says Shailendra Kumar. Investors should reduce allocation to equities when the PE of benchmark indices is above 24 and increase when it is below 16. The same rule can be used to decide on asset allocation within asset classes. The allocation to mid-cap stocks can be kept low now because the PE of BSE Midcap index is placed at 33.64 compared to the Sensex PE of 22.69. Similar valuation based rules can be used to fix allocation for other asset classes. One can reduce long-term debt in a rising interest rate scenario and increase it when rates are falling.Special rule for first-time investors: New investors need to understand the meaning of long-term investing. “One year holding period is considered long-term for equities for tax purposes. But equity investors should hold for at least five years because economic cycles last much longer,” says Joshi. Please note that this five-year threshold is for large-cap stocks. Mid-cap and small-cap stocks may need to be held for longer periods.First-time investors need to be especially careful. “Risk takers among first-time investors can invest small amounts in aggressive equity funds,” says Agarwal. The high volatility in these segments will help them understand the risks better. But since the amount invested would be low, the loss would also be limited. “Asset allocation funds or hybrid funds are good for first-time investors because the asset allocation changes automatically,” says Joshi.Don’t ignore other asset classes: While most investors have some exposure to domestic equities and debt, they usually ignore other asset classes. Financial planners don’t suggest real estate (other than primary residence) because property is very illiquid. Though Indian investors won’t sell their gold ornaments, most will have enough gold exposure through this route. One advantage of gold is that it is an international commodity and therefore, will act as a hedge against rupee depreciation. However, experts suggest international equity funds as a better alternative to gold (see guest column). “Investors should have around 20% of their equity allocation in international equity,” says Bajaj. Some international funds have delivered good returns in the past (see table).Don’t over-diversify: Some investors tend to assume that the greater the diversification, the better it is. They keep adding stocks to their portfolios. According to modern portfolio theory, 15-20 stocks from different sectors are enough to make a well diversified equity portfolio. This is because diversification can reduce risks only up to a limit. Since the market risk (known as systematic risk) can’t be diversified away, there is no purpose in continuing with diversification after that.Does this rule apply to India as well? We have 18 main industry classifications and picking one stocks from each will give you 18 stocks. If you avoid 2-3 sectors because you are bearish on them, you still have 15 to choose from. These 15-odd stocks should be enough for a portfolio of Rs 50-60 lakh. However, the situation changes for investors with larger portfolios. “Since the liquidity is not very high in India, investors with large corpus are forced to invest in more than one stock from each sector. This explains why mid- and small-cap oriented schemes have a large number of stocks in their portfolio,” says Shailendra Kumar.Diversification reduces but doesn’t remove the risk in stock investing15-20 stocks from different sectors can effectively remove the diversifiable (unsystematic) risks in a stock portfolio. 64895270 Number of mutual fundsMany investors also tend to binge on funds. Since mutual funds already hold a diversified portfolio of stocks and bonds and there is a lot of overlap in companies held by funds, there is no need to go for large number of schemes. “Around six schemes are enough for a mutual fund portfolio of any size. Four equity funds, one liquid fund and one shortterm debt fund is all you need,” says Joshi. Bajaj concurs with this view. “Ideally, no single scheme should have more than 20% corpus (increases risk) and less than 10% corpus (impact is insignificant),” he says.Changes in asset allocationThe asset allocations discussed till now are structures needed at the time of investments. For example, you may have a 100% equity allocation for a goal that is 15 years away. But what should you do when your goals come nearer? Experts say that you need to shift to debt 1-2 years before the goal date (in year 13 or 14 in this case). A lot will depend on the market situation also. Get out earlier if the markets are overvalued, and wait a little longer if they are down. A fixed formula can be risky because the equity market may be in doldrums during the 14th year. Gradually shifting from equity to debt is the only solution for it. “Instead of shifting the entire corpus just one year before goals, investors should start shifting from equity to debt in a gradual manner (shift 20% per annum to debt from 11th year onwards for a 15 year goal),” says Bajaj.This kind of shift from equity to debt also depends on the type of goals and the way money is needed for them. For example, money is needed in lump sum for a daughter’s wedding goal. However, money requirement will be staggered for her education goals (assuming four years of graduation and two years of post-graduation). “If only a portion of goal value is needed in a year, shift only that part from equity to debt in advance,” says Joshi.

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