The objective of any portfolio is to accumulate wealth, which you convert into cash at the end of the time horizon to meet your life goal. The investment-to-cash process involves managing risks associated with equity investments; failure to do so could mean that the portfolio proceeds at the end of the time horizon may not be enough to meet your goals. Here's how to convert your investments into cash.

For short-term goals

The investment-to-cash process is based on your time horizon. Your life goals are defined in two time blocks — time horizon of five years and less and time horizon of more than five years. You should invest only in bank fixed deposits to meet your life goals with time horizon of five years and less as your risks are greater if you invest in equities. If the market tanks, especially as you near your goal, you have limited time to recover your unrealised losses. Furthermore, it doesn’t take much time to wipe out your potential profits.

With deposits, the investment-to-cash process is simple. Ideally, you should invest in a recurring deposit with maturity coinciding with the time horizon of your life goal.

For long-term goals

The investment-to-cash process for life goals with time horizon of more than five years is different as such goal-based portfolios contain equity investments. Equity subjects you to several associated risks.

The investment-to-cash process to moderate this risk contains two steps. Let’s take the first step. .Assume your portfolio has to generate 10 per cent compounded annual return to achieve a goal in 12 years. Now suppose your portfolio generates 14 per cent return in the third year. You thus have excess returns of four percentage points. You should sell assets in your portfolio to the extent of four percentage points and invest the proceeds in bank fixed deposits. Try to coincide the maturity of these deposits with the residual time horizon (nine years).

You can also use this deposit in any subsequent years till the sixth year to invest in equity if the actual unrealised gain is less than the required return of 10 per cent. Step 2 has to be initiated in the seventh year — five years before the end of the time horizon. At this time, you have to significantly reduce your equity allocation to about 25 per cent with the balance in fixed deposits that mature at the end of the time horizon.

Residual equity

You may have observed the contrasting suggestions — life goals with time horizon of five years or less do not contain equity investments whereas life goals with residual time horizon of five years contain about 25 per cent equity.

The portfolio with a time horizon of 12 years, perhaps, had initial equity allocation of 60 per cent. Because equity has higher expected return, your monthly capital contribution into the investment account is lower compared to a portfolio that contains only fixed deposits with the same time horizon. Now, you may, as it is, have to increase your capital contribution from the seventh year to the twelfth year to bridge the decline in expected returns as you reduced equity allocation. If you bring equity allocation down to zero instead of 25 per cent as suggested, it would stress your cash flow unduly. If you can contribute the higher required capital, however, you can bring your equity allocation to zero.

The author is the founder of Navera Consulting. Feedback may be sent to portfolioideas@thehindu.co.in

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