Are stable cash flows ‘safe' investments?

Investors typically size their equity allocation based on market movements. That is, these investors have large equity allocation when the market moves up and insignificant allocation when the market declines. Some, in fact, cut equity exposure and move into bank fixed deposits, promising never to invest in equity again. Such allocation can be sub-optimal and risky.

This article explains why stable investments such as bank fixed-deposits are not necessarily “safe” for meeting lifestyle needs. It then discusses how investors can create a portfolio containing a judicious mix of equity and bonds that will help them achieve their investment objectives.

Safety Vs Lifestyle

Individuals like to maintain their present lifestyle, if not better it. Investment portfolio should be geared towards meeting such lifestyle requirements. During the working years, an individual's typical requirement is to buy a house and fund children's education.

In the later years, it is the need to maintain a comfortable post-retirement living. The portfolio risk should, hence, be defined not in terms of the loss in investment capital but in terms of the inability to reach the investment objective due to adverse movement in asset prices.

Suppose a young investor has a 10-year time horizon to buy a house. Assume her initial investment capital is Rs 10 lakh, her monthly contribution is Rs 35,000 and the proposed house value is Rs 1.5 crore. She will need just over 15 per cent a year for 10 years to reach her investment objective. The portfolio risk can be defined as the risk of not earning the required return of 15 per cent each year. Given this argument, it would be easy to appreciate why stable investments are not necessarily “safe” in the context of achieving the investment objectives. Consider the bank fixed-deposit. Even if interest rates were to increase, having a portfolio predominantly constituting bank deposits is unlikely to help the young investor reach her investment objective.

The reason is because interest on fixed deposits will typically fall far short of 15 per cent return required each year. Stable investments, hence, lead to comprise in lifestyle needs. The question then is: How should individuals create their portfolios?

Optimal portfolio

An optimal portfolio should contain a judicious mix of equity and bonds. The portfolio construction process should be sensitive to the investor's risk attitude. The risk attitude is a function of the investor's ability and her willingness to take risk. The ability to take risk is a function of her current wealth, recent loss experience and investment horizon.

Generally, objectives with longer investment horizon should have higher equity allocation; for the portfolio will have time to recover losses, if any, suffered during the initial years of investment.

The willingness to take risk is the function of risk perception. Sometimes, a wrong perception can make an individual assume risk that is not in sync with her risk ability. A wealthy individual, for instance, may want to take low risk while a mass affluent individual with low ability to take risk may want an aggressive portfolio.

One way to sync individual's willingness with her ability to take risk is to allocate equity based on the worst-case loss that such investments can have in any year. This can be measured by calculating annual returns of a broad-based index such as the S&P CNX 500 in the last 10 years.

This process will not reduce the pain when the investment actually goes down in value. But it would discourage hasty decision to sell equity investments and move to fixed deposits when prices decline. This could happen because, the individual's loss tolerance will be higher as she will be emotionally tuned to expecting such losses.

Fixed deposits no doubt provide stable cash flows. But such stability does not make investments “safe” in the context of achieving the investment objectives. Individuals require a judicious mix of equity and bonds to improve their chances of meeting their desired lifestyle needs. Instead of avoiding equity fearing the downside, individuals should create portfolios that align asset allocation with their risk attitude.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor learning solutions. He can be reached at > enhancek@gmail.com)