Simple Steps to De-risk Your Investment Portfolio
The recent upward swing in the markets has left most people happy. Some are excited because they have never seen wealth grow at such a frantic pace and some are just happy – happy that their convictions and time in the market has paid off.
While current market valuations are still on the reasonable side (Nifty PE ~ 20.2 and CNX 500 PE ~ 20.7) and one can still invest, to gain from this upward movement we must go easy on the euphoria and train our minds to become fearful.
Yes fearful – As Waren Buffett said be greedy when others are fearful and fearful when others are greedy.
While most investors are dreaming about this bull run and how it will create wealth for them, ones time is better spent in learning how to reduce risk in ones portfolio.
The key aspect of investing in volatile instrument is not gains but preservation of gains.
All well to the ride the bull and enhance portfolio value. If the market corrects, your folio should correct less – much less.
That is the secret to wealth building – reduce the volatility in portfolio returns but at the same time keep the net return well above expectations.
Accomplishing this is easier than you think or anyone might lead you to think!
Here are some simple steps to de-risk your investment portfolio
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.
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…… ]duration
So the key is to stay the course.
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 (debt instruments) bonds to reduce the overall risk to the folio.
Here safety refers to the poor correlation between the movements of equity markets with debt markets. Fluctuations in one will little affect the other.
How much should the equity:debt proportion be depends entirely on the goal duration and nature. Here is an example
The simplest and most important measure of risk investors must understand is thestandard 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 guideto help you do that.
As a general thumb rule, lower the investment duration, lower should be standard deviation of the instrument.
For example, choosing an equity oriented balanced fund for a 5-year investment duration is madness.
Diversification is the second most important step (expecting less is the first). Use this toolto 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.
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.
The following, although not difficult to understand is recommended only for experienced investors with big folios.
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 latter.
A simple indicator market valuation is the P/E ratio or the price/earnings ratio.
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 extra-ordinary 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 for those who are focussed on the net portfolio returns.
Tactical asset allocation is not profit booking.
This means the last two 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, two years before the actual goal date, much of the corpus is accumulated, and can be kept away safely.
There is no need to this while planning for retirement, provided one started early and invested enough. Do you know why?
While current market valuations are still on the reasonable side (Nifty PE ~ 20.2 and CNX 500 PE ~ 20.7) and one can still invest, to gain from this upward movement we must go easy on the euphoria and train our minds to become fearful.
Yes fearful – As Waren Buffett said be greedy when others are fearful and fearful when others are greedy.
While most investors are dreaming about this bull run and how it will create wealth for them, ones time is better spent in learning how to reduce risk in ones portfolio.
The key aspect of investing in volatile instrument is not gains but preservation of gains.
All well to the ride the bull and enhance portfolio value. If the market corrects, your folio should correct less – much less.
That is the secret to wealth building – reduce the volatility in portfolio returns but at the same time keep the net return well above expectations.
Accomplishing this is easier than you think or anyone might lead you to think!
Here are some simple steps to de-risk your investment portfolio
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…… ]duration
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 (debt instruments) bonds to reduce the overall risk to the folio.
Here safety refers to the poor correlation between the movements of equity markets with debt markets. Fluctuations in one will little affect the other.
How much should the equity:debt proportion be depends entirely on the goal duration and nature. Here is an example
Returns indicated are before taxes!
4 Choose wisely
Conservation asset allocation and return expectations are important but about to nothing if the right kind of investments are chosen.The simplest and most important measure of risk investors must understand is thestandard 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 guideto help you do that.
As a general thumb rule, lower the investment duration, lower should be standard deviation of the instrument.
For example, choosing an equity oriented balanced fund for a 5-year investment duration is madness.
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 toolto 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.
6 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 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.
7 Tactical asset allocation
All of the above mentioned points can be (and should be!) implemented by all retail investors on their own.The following, although not difficult to understand is recommended only for experienced investors with big folios.
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 latter.
A simple indicator market valuation is the P/E ratio or the price/earnings ratio.
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 extra-ordinary 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 for those who are focussed on the net portfolio returns.
Tactical asset allocation is not profit booking.
8 Quit while ahead
Equity holdings should be decreased gradually as the goal approaches. Two – three years before the deadline, the portfolio should be in pure low volatile debt instruments with no equity.This means the last two 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, two years before the actual goal date, much of the corpus is accumulated, and can be kept away safely.
There is no need to this while planning for retirement, provided one started early and invested enough. Do you know why?
~~~~~~~~~
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.
No comments:
Post a Comment