The risks associated with your portfolio depend on the sources of returns and the phase of your life. For instance, you may be subject to a different risk on your bank deposits during your working life compared to your retired life. Here, we discuss the risk associated with your income returns. We also suggest ways to moderate this risk.

Risk transformation There are two sources of return on investment — income return and capital appreciation. The risks associated with income returns are different from those associated with capital appreciation. Further, the risks associated with income returns are different before and after retirement. Why?

Your investment portfolios’ objectives are different during your working life compared to your retired life.

Consider the retirement portfolio that you create during your working life to retire rich. This typically, contains bonds and equity. The income returns on equity are dividends and that on bonds is interest.

Given the low dividend yield in recent years, your primary source of return on equity is capital appreciation. Your primary source of return on bonds is interest income. As an individual investor, you are likely to invest in bank deposits and hold them till maturity.

Your retirement income portfolio will also contain equity and bonds. Yet, the portfolio’s objective is different. During your retired life, you need stable cash flows to sustain your monthly living expenses.

So, your retirement portfolio is an accumulation portfolio whereas your retirement income portfolio is a decumulation (spending) portfolio. This affects the risk associated with income cash flows.

How? The cash flow from income returns on your accumulation portfolio has to be reinvested till the end of the time horizon to meet the life goal for which it was intended. You are, therefore, exposed to reinvestment risk.

The risk is that, you may have to reinvest the interest income at a rate that is lower than the return required for achieving your life goal. The interest income on your decumulation portfolio has to be consumed.

So, it does not suffer from reinvestment risk, but is subject to inflation risk.

Risk moderation You can moderate reinvestment risk in your accumulation portfolio by investing in bonds that do not pay annual interest. Suppose you want to invest in a bank deposit for three years to make down-payment for a house.

You should choose a three-year cumulative deposit instead of an annual-pay deposit. If your deposit earns 8.5 per cent pre-tax interest, the bank will reinvest the annual interest at 8.5 per cent. So, the bank assumes the reinvestment risk.

Of course, all bonds do not offer cumulative interest. Tax-free bonds issued by the government typically pay annual interest. You should not spend this interest income on discretionary and non-discretionary expenses.

That will lead to failure to meet your life goal because interest income has to be reinvested at the required rate to accumulate wealth. So, you should adopt a process to reinvest such cash flows.

One such process is to have a master investment account (savings account to route your investments) linked to your demat account.

This way, the annual interest credited directly to your master investment account will be part of the investment cash flows. You can periodically reinvest these cash flows based on your asset allocation strategy.

But what if you are a retiree? The risk associated with your income returns is primary related to inflation. This is the risk that your interest income may not keep pace with the increase in prices. This means the monthly cash flows may not be enough to meet your lifestyle expenses. There are no products that pay inflation-adjusted interest income. So, you have to moderate your inflation risk by investing in equity, as expected returns on equity are higher than inflation rate.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in

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