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Controlling Risk!!!

 SEBI has recently introduced a new category of fund – Lifecycle funds. These are essentially target date funds – they mature on a target date and proceeds will be returned to the investor on maturity date automatically. The premise of this fund category is – allocation to risk assets like equities need to be reduced as target date approaches to ensure accumulated corpus is shielded from severe equity market downturns close to target date.

Long story short – the idea is to lower your risk progressively as the target date approaches.

Though this is not what has made news.

Investors have been taken in more by the fact that such funds will be considered as equity funds throughout their lifecycle and no tax liability will lie on the investor when the periodic switch from equity to non equity funds and vice versa happens. Never mind such flexibility and maybe better tax efficiency exists already in NPS system, though with “lock-in” cost thrown in. Again, never mind the tax efficient partial withdrawal facility available in NPS!!!

Let’s keep the tax efficiency part aside and circle back to “reducing risk progressively” part. Is there a more appropriate way to control risk in your portfolio? I am more with this suggestion given to retirees by Charles B Ellis in his book “Winning The Loser’s Game”:

“Put a rolling five years’ expenditures in medium term bonds and the rest in equities the year you retire. Each year, convert one more year’s spending from equities to bonds unless the market is high and all the chatter is about good prospects – in which case, you’ll be wise to convert two years: if the chatter is about great prospects, covert three. Yes, this is a form of market timing, but it’s seldom a bad idea to lean against the wind”


    I have mentioned this quote earlier also in one of my previous blogs here.

What the author is advising is very simple: do not take any risk with the money you may need in short term. Don’t just reduce risk – make it nearly zero. I am totally with this view because of following historical equity markets performance figures*** for 5 year horizon:

-          Probability of losing money: Nearly 1%. Statistically insignificant, but still there.

 

-          Probability of making 0% to 8% annualized return: Nearly 14%. Now this figure is very much statistically significant. More so, it is dangerously close to what low risk debt instruments may offer

 

For me, simple way works better – divide overall assets into two parts:

-          Short horizon: Funds which maybe required within 5 years. NIL risk assets exposure here. If I want to be a bit adventurous, maybe I can look at maximum 10% risk assets exposure

-          5 years and beyond: 75% risks assets exposure. Maybe even 90% if one has reasonable steady source of income and has a sizeable corpus in “short horizon” portfolio

This method also manages emotional risk – it is very difficult to stay out of equity markets when new highs are being made every other day. Dividing the portfolio as above ring fences reasonable part of my capital from “Greed” risk as well!!!

***Basis Nifty 500 Total Returns Index for nearly 20 years historical period!!!

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