Personal Finance

Managing portfolio risk as your goals near

B Venkatesh | Updated on September 08, 2019 Published on September 08, 2019

As the target gets closer, you will be anxious to protect your existing portfolio value

Picture this: two years hence, your child will enter college. You have been diligently investing in her college fund for the past 10 years. The fund is now significant, but you have to accumulate some more in the next two years to meet the education cost. You are justifiably anxious. What if the stock market tanks? Should you switch to bank deposits now to protect your existing portfolio value?

These are typical questions that individuals face when they are closer to the end of the time horizon for a life goal. In this article, we discuss how you should moderate your portfolio’s risk during the ‘anxiety zone’.

Anxiety zone

We define anxiety zone as the last five years of the time horizon for a life goal. If your child has 12 years to enter college and you have just started investing for her education fund, the anxiety zone is the period from years eight to 12. Why five years?

Suppose you want to accumulate ₹1 crore in your child’s education fund. You already have ₹75 lakh consisting of 50 per cent equity and 50 per cent debt. You are planning to contribute ₹25,000 every month for the next 24 months, at the end of which your child will enter college. What if your equity investments decline by 20 per cent during this period? True, it is only unrealised losses. But what if you do not recover these losses by the end of two years? Your child’s education fund will have a shortfall when you eventually liquidate the investments to pay for her education. That is, unrealised gains turn into realised shortfall. Why?

It typically takes a while to recover unrealised losses on equity investments. Now, five years is a fair time to let your portfolio heal, i.e., recover a sizeable proportion, if not all of the unrealised losses. We call this period the anxiety zone because you are ‘anxious’ to protect your existing portfolio value using stable investments and yet have a fully funded portfolio at the end of the time horizon for a life goal.

How should you manage your portfolio’s equity risk during the anxiety zone and also meet your life goal without cutting current consumption?

Managing anxiety

You have to first determine if the goal you are pursuing can be postponed. If your answer is no, the goal is high priority. For two portfolios with the same time horizon, the one relating to a high-priority goal will always have significantly lower equity allocation than the one relating to a low-priority goal. Further, you should decrease your equity allocation and move the proceeds to stable investments for both portfolios as you enter the anxiety zone.

This process calls for a trade-off. If you want stable investments, you have to invest more in bank deposits.

And that means greater investment capital to accumulate the same wealth because bank deposits have lower expected returns than equity. So, what should you do?

First, move your entire portfolio to bank deposits when you are in the anxiety zone. Then, set an equity allocation that you are comfortable with (say, 40 per cent). Assuming post-tax returns of 10.8 per cent on equity and 4.7 per cent on deposits, the weighted expected portfolio return with a 40:60 allocation is 7.14 per cent. Next, determine how much you have to save every month so that the lump-sum bank deposits along with the monthly contributions accumulate to the target portfolio value five years hence. You can, if necessary, increase your existing monthly contribution by saving more from your yearly salary increase.

What if you still have a shortfall at the end of the time horizon for the life goal? You should transfer investments from your retirement portfolio or from a low-priority goal, or resort to short-term borrowings to bridge the shortfall.

The writer is founder of Navera Consulting. Send your feedback to [email protected]

Published on September 08, 2019
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