by Anand Saxena
Safety or security bucket investment instruments will contain the following:
Cash: Having some cash in savings bank account or in money market instruments (these are debt investments for one year or less period with high liquidity) is a must for emergent situations. In the 2008 stock market crash, when Sensex dropped more than 50 percent, it was not wise to take out money from stock market or other debt instruments. Having cash for such situations is a hedge against turbulent market conditions or exploiting a financial opportunity which requires immediate investment. We have already discussed the breathing fund which should suffice as a cash hedge under normal circumstances.
Bonds: Bonds are loans given to the government or other entities and come with different tenures of maturity periods and risk ratings, the highest of which being AAA. We will discuss bonds in detail under the relevant musing but it suffices to know here that whenever the interest rates go up, the bonds prices go down and vice versa. Bonds can also be purchased through the mutual fund route by investing in bond funds.
Fixed Deposits: Here you loan money to the bank or Non-Banking Financial Company (NBFC) who promises to repay the principal along with interest. One can also invest in Fixed Maturity Plans (FMP) which in turn invest in various debt instruments, certificates of deposit (CDs) and commercial papers (CPs.) These offer higher rates of returns albeit with higher risk.
Pension: A government job offers you pension once you retire. There are also various plans available in the market, which offer you a lifetime pension (annuity) on payment of either a lump sum or periodic payments. As a pension or annuity guarantees a fixed sum, the returns are lower.
Life Insurance: Life Insurance has already been covered under the musing of insurance and should be construed as a necessity to cater for the unfortunate and untimely demise of the bread earner of the family. Returns, if you survive, are not the criteria.
The risk or growth bucket will typically contain the following financial instruments:-
Equity: Equity can be purchased in various forms like direct stock trading in stock market, mutual funds, Exchange Traded Funds (ETF) and Index Funds.
Commodities including Gold: Commodities also offer huge upside with attendant risk. Gold has been especially popular in the Indian context. The real returns in gold investment have been generally poor and hence it could be looked at as a hedge against inflation or falling market conditions.
Real Estate: There is one commodity that will probably straddle both the buckets and should ideally be part of none of them—your home. As already discussed, home should be considered as a basic human need for shelter and not really an investment. Traditionally, house prices have only gone up in line with inflation in the long run. Then is also the issue of liquidity in real estate investment. When you need the money, it might not be available in a hurry. In times to come there might be other avenues to invest in commercial real estate like Real Estate Investment Trusts (REIT) which trade like stocks and are popular in developed countries like the U.S.
As this book is meant for an average investor, one should only look at the four asset classes: equity, debt, real estate and gold, for investments. Ideally, one should keep the investments in one’s portfolio spread across these four asset classes. The next question naturally is how much of each asset should one keep in one’s portfolio and indeed what exactly is a portfolio? We tackle this issue in the very next musing.
Key Takeaways
In order to earn stable returns well above inflation, one needs to invest across all major asset classes: equity, debt, real estate and gold.
The key decision is on the percentages of each asset class in the portfolio which may vary according to one’s age, goal, time and risk capacity.
MUSING 15: MODERN PORTFOLIO THEORY
RISK AND REWARD PARADIGM
“Risk and risk alone determines the degree to which returns will be below or above average31.”
If we analyse the Indian economic cycles post liberalisation in 1991, we find that the GDP growth has averaged around 6.5 percent in the period 1991-2016. Buoyed by this positive market sentiment, the Sensex, which began its journey with a value of 100 in 1979-80, has multiplied 34 times in this period. Simply put, if someone had invested ₹1 lakh in the stock market in 1991, it would have become ₹2.53 crores today (₹4.76 crores including dividend yield at the rate of 2 percent,32) a phenomenal growth indeed. But has this growth been linear? On the contrary, the stock market has had its own roller coaster ride along the way, with seven bull market and six bear market phases (we will get to these terms soon.) On an average, every eighth year the Sensex has fallen by more than 50 percent but at the same time, there have been phenomenal upsurges like between March 2009 and November 2010, when the Sensex soared by 162 percent. Clearly, higher risk in equity gave correspondingly higher returns.
So if Anshreya had retired in the year 2008 with one hundred percent equity portfolio, she would have seen her retirement corpus erode by more than half within days. Yet, if she had retired in the year 2009, she would have seen her portfolio grow one and a half times within weeks. The only problem is that one wouldn’t know beforehand as to which market cycle one would encounter at retirement or a time-bound financial goal.
Having seen the violent moves of equity in last 25 years, let’s see what the other asset classes were up to? We compare the returns (CAGR—we will take on the definitions of different types of returns in subsequent musings,) of major asset classes in 2008, a year of worldwide recession. Equity fell by a staggering 51.84 percent while gold gave a brilliant return of 26.15 percent. Debt instruments also gave a decent return of 5.79 percent. We thus see that the asset classes generally tend to move in opposite directions in different market cycles and hence a portfolio must comprise of all asset classes to hedge against this phenomenon as no one can predict the market behaviour.
One obvious question is why one’s portfolio cannot be wholly made of debt instruments, gold or real estate if one wants to play safe? The reason is that the historical returns of these asset classes have barely beaten inflation. It is only equity which has given consistent inflation-beating returns. The historical data of annualised returns of these major asset classes since 1980 is given below33 :
• FD (debt): 8.39 percent, Gold: 10.21 percent and Sensex: 16.13 percent (18.13 percent if dividend yield is also factored in,) without catering for inflation.
• The real returns (inflation adjusted): FD (debt): 0.72 percent, Gold: 2.54 percent, and Sensex: 8.46 percent (10.46 percent including dividend yield.)
Modern Portfolio Theory
The Modern Portfolio Theory (MPT) was conceptualised by Harry Markowitz in 1952 for which he won a Nobel Prize in 1990. This theory is based on the premise that all the major asset classes (equity, debt, gold and real estate) come with their inherent risks and rewards and hence need to be optimally mixed as a whole in one’s portfolio to ensure that they act as a hedge against each other under different market conditions. A portfolio is nothing but a holistic view of all the investments one has made or is making without being unduly bothered whether one or the other component of the portfolio is not doing well, as long as the portfolio as a whole is generating positive returns.
What Markowitz found was that if one mixes stocks of variable volatility in one portfolio, the overall portfolio volatility went down or in other words the portfolio became less risky than its constituents individual stocks. Of course, for this to happen, the stocks in the portfolio should be ‘negatively correlated’ meaning if one of them went up the other came down. In such an ideal condition, diversification will totally eliminate risk. In actual life though, such ideal scenario doesn’t happen and in cases of severe recession or if the market crashes all stocks (and asset classes) may go down together, albeit at different percentages.
Risks are of two types—systematic and unsystematic. Systematic risks, also called market risks, are the reaction of individual stocks to general market movements. So, if the market
goes up, generally stocks will tend to go up and vice versa. Of course, the degree of movement will not be uniform. For a market drop of say, 10 percent, some stocks may go down by 5 percent and some by 15 percent. This relative volatility or sensitivity of individual stocks to overall market movements is called ‘beta.’
The remaining variability in a stock’s movement is called unsystematic risk and depends on factors particular to that sector or stock. For example, a stock investing in mining industry may lag the general market upswing due to overall mining sector being in recession.
The broad market index like Sensex is assigned a beta value of 1. If a stock has a beta of 2, it will be twice as volatile as the market movement. If the market goes up by 10 percent, this stock will go up by 20 percent, but also fall by 20 percent when the market goes down by 10 percent. Similarly, a stock with beta of 0.5 will be more stable than the market. Fixed income or debt instruments have relatively lower beta as the returns, in the form of interest, are fixed. To take the example of fixed deposits up to ₹1 lakh, their beta will be zero, as this amount is guaranteed to the investor by the government. Axiomatically, the returns of fixed income or debt investments are going to be lower as one is bearing lesser risk.
The important thing to remember is that diversification only eliminates or reduces the unsystematic risks and not systematic risks. Taking our example of mining sector stock, which has gone down due to mining sector recession; this risk can be obviated if we hold other stocks of say IT sector or infrastructure sector and so on in our portfolio. Hence a well-diversified stock portfolio will only have systematic risk i.e. risk of the entire market falling. This is the reason equities are considered riskier but tend to give outstanding returns in the long run.
But then how many stocks should one hold in one’s portfolio to achieve ideal diversification? “It is about twenty equal-sized and well-diversified U.S. (read Indian for this musing) stocks (clearly, twenty oil stocks or twenty electric utilities would not produce an equivalent amount of risk reduction.) With such a portfolio, the total risk is reduced by about 70 percent. And that’s where the good news stops, as further increases in the number of holdings do not produce any significant additional risk reduction34.”
The outcome of understanding the risk-reward paradigm is that one can adjust the expected returns (and volatility) of one’s portfolio by adjusting the beta of the portfolio. For example, if one invests ₹50,000 in fixed deposit (zero beta) and ₹50,000 in well-diversified stocks (beta of 1,) the overall portfolio beta will be 0.5. Hence, one will capture sizeable market returns, more than fixed deposit, without too much of volatility of stocks.
This brings us to the beauty of investing through mutual funds. Let us see what mutual funds do. They contain portfolio of more than 20(generally) well-diversified stocks thus reducing the unsystematic risk substantially. They also select stocks in a manner that the overall portfolio returns are more than the expected returns as per the beta of the portfolio. More astute fund managers are thus able to provide beta beating returns and are said to be giving positive alpha35. The only problem is that “it is very difficult (indeed probably impossible) to measure beta with any degree of precision36.”
The message is loud and clear. “It’s important that you manage all your financial assets—retirement account, taxable account, kid’s college money, emergency money etc. as a single portfolio which must comprise of a happy mix of all the asset classes37.” Investing in only one asset class, akin to putting all the eggs in one basket can result in a poor retirement or very modest returns thus not achieving one’s financial aspirations. Yes, one can get fantastic returns by being fully invested in equity but that would be more a matter of providence and not planning. In the next musing, we will try and answer the riddle—how much one should invest in each of the asset classes?
Key Takeaways
A portfolio must consist of all the major asset classes, the percentage of which will vary with one’s financial goals, age, risk capacity and other factors.
The returns from one’s portfolio must be seen holistically as obtained from all the asset classes contained in it without bothering about individual returns of any asset.
MUSING 16: THE ASSET ALLOCATION
“In 1986, three researchers, Brinson, Hood and Beebower, showed in their landmark paper that over 90 percent of your portfolio’s risk-adjusted return is connected to your asset allocation. This finding rocked the finance world38.”
We have seen in the previous musing that in investment, risk and rewards are intrinsically linked. If one wants to totally eschew risk, he will have to be content with modest returns which barely beat inflation like in bank FD. On the other hand, a very aggressive investor who puts all his money in equity may find him very rich or very poor depending on the market cycle during investment and withdrawal.
We also learnt about the MPT which states that it is the mix of asset classes in your portfolio which should be of most concern to you. This asset mix is the only thing in your control and not the returns that you would accrue from individual assets. By having a prudent asset allocation mix one can ensure that the portfolio as a whole will give positive returns irrespective of market conditions. Hence, one should treat all the investments, be it for retirement, children education and so on as ‘one single portfolio.’ We have already established that real estate and gold cannot really be construed as assets for investment purpose and hence that leaves us with two broad asset classes—equity and debt. It is the optimal mix of these two which is the alchemy of investment that one should desire for.
Before we progress further, it is good to understand the difference between asset allocation and diversification, both terms used interchangeably, which is wrong. Asset allocation, is dividing your investment between four major asset classes (for a common investor): equity, debt, real estate and gold. Diversification, on the other hand, is division within an asset class. So, the equity part of the portfolio could be diversified amongst individual stocks, domestic diversified equity mutual funds, global funds and so on. This musing is about asset allocation and the diversification part will be handled in the relevant musing(s), particular to an asset class.
The first step towards asset allocation is to ascertain one’s ‘risk capacity39’ which comprises five factors:
• Time horizon and liquidity (ready availability of cash) needs.
• Risk tolerance or attitude towards risk.
• Net worth.
• Income and savings rate.
• Investment knowledge.
Individual risk capacity is a must to be gauged to ascertain that if the stock market plummets 25 percent, will you lose your sleep? Or if it loses 50 percent, will you rush out of the market? This is a very crucial decision as one should always invest with a long-term view. If the market drops below your risk tolerance threshold there is a danger that you will get out of the market thereby suffering irreparable losses and probably never to return to equity investment again. As Burton Malkiel says in his book ‘A Random Walk Down Wall Street,’ “Every investor must decide the trade-off he or she is willing to make between eating well and sleeping well.” Tony Robbins, in his book, ‘Money-master the game’ has provided the following link which is a good start point to ascertain one’s risk tolerance.
http://njaes.rutgers.edu/money/riskquiz
There is a good rule of thumb to follow for asset allocation. The percentage of debt instruments in one’s portfolio should be roughly equal to one’s age or maybe even age minus 10 percent, the remainder being in equity40. So, as Anshreya begins to earn at 25 years of age, she should invest 15 to 25 percent in debt and 75 to 85 percent in equity instruments. But, is there a case of 100 percent debt or equity investment ever?
Indian stock market and its indices BSE Sensex and NSE Nifty are relatively new, having been launched in 1986 and 1996 respectively. The data range to analyse Indian equity return is thus very narrow, just about 31 years. The data of barely three decades is
considered inadequate for analysis by most financial pundits. Sample this quote from William J Bernstein, from his book ‘The Four Pillars of Investing.’
“Ignore the past ten years. Recognise that the returns data for an asset class of less than two or three decades are worthless.”
The real long-term analysis to ascertain the optimum asset allocation mix is thus only possible by analysing the Western stock markets which are much more mature and hence looking at a 100-year dataset is bound to bring out valuable lessons. We will study the empirical data of the U.S. market, provided by a table of 100 years’ annualised returns for the years 1901-2000 with various combinations of stock and bond (debt) mix and comparing these with the returns obtained in the bear market of 1973-74 which lasted for nearly two years and in which the S&P 500 index of the U.S. fell by 48.0 percent41. Just to recap, a bear market is said to occur when the stock market falls more than 20 percent from it’s 52-weeks peak which lasts more than two months.
Before we dive into the analysis, it is worth our while to note few more relevant aspects.
After the year 2000, there have been two major worldwide bear market phenomenon. The first from March 2000 to October 2002 (30 months,) also called the dotcom burst, in which S&P 500 lost more than 49 percent42 and BSE Sensex more than 58 percent. The second bear market occurred from October 2007 to Mar 2009 (17 months) which is also called the subprime crisis in which the S&P 500 lost more than 56 percent43 and BSE Sensex more than 61 percent. Very clearly, the global financial markets are interlinked and happenings in faraway places may give a jolt to common equity investors in India.
