Allow your equity to slide with age

Your investment portfolio should contain both equity and bonds, whether you are a working professional or a retiree.

Of course, with equity investments come associated risks; you could fail to achieve your life goal if the stock market declines sharply, whether at the beginning or at the end of your investment horizon.

The question then is: What proportion of your total portfolio should you invest in equity and how should you manage the risk? Here we use the concept of glide path to show how you can size your equity allocation during your working and post-retirement years.

Pre-retirement equity You can use the concept of glide path to set the proportion of equity in your portfolio. Think of the glide path as the children’s slide in a playground. A child climbs the steps to reach the top of the slide and then glides to reach the ground.

Likewise, you should increase your equity allocation at an increasing rate from the start of your career till you reach, say 75 per cent allocation at age 40. This is akin to the child climbing the steps to reach the top of the slide.

You should thereafter reduce your equity allocation between age 45 and 55 such that you have about 25 per cent allocation at 55, continuing till your retirement at 60; this is akin to the child sliding to the ground.

This equity glide path is based on the following arguments. One, you may be unable to reap the benefits of higher return on equity during your early career because the capital you invest is typically small. You should, hence, increase your equity allocation as your income increases.

And two, your equity allocation is a function of your ability to earn. Now, your earning ability is higher when you are in your mid-career than in your early career. So you should gradually increase your equity allocation in line with your income stability.

Post-retirement equity Now, your retirement income portfolio can be a stock-bond portfolio or a bucket portfolio, where different assets are mapped to different needs.

How should you tailor your equity allocation if you have a stock-bond portfolio? You should follow the same process as in your working life. Increase your equity allocation gradually from the start of your retired life such that you have the highest allocation you are comfortable with (say 25 per cent) by age 75.

You can increase your equity allocation by systematically transferring money from fixed deposits to an equity mutual fund.

Thereafter, you should reduce your equity allocation such that you cut your allocations to a minimum (say 10 per cent) by age 90. This reduces your equity investment risk as you near the end of typical life expectancy.

The argument for such a strategy is as follows: As a retiree, your primary risk is longevity. This is the risk that you will outlive your investments. The longevity risk, in turn, is related to the sequence of returns from stock markets.

That is, your portfolio value can be vastly different depending on how the stock market performs during the early years of your retirement. If you experience positive returns early in your retirement, your portfolio could last through your lifetime. But if you suffer heavy losses during the early years of your retirement, you could outlive your investments!

While we have talked of indicative allocations, your actual equity allocation should depend on the importance of your life goal, the higher the priority of your life goal, the more conservative your investments should be.

And remember this: your equity glide path is important to achieve your life goal, irrespective of whether you are working or you are a retiree.

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

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