by Anand Saxena
Though the data under analysis is of the U.S. stock market and slightly dated, there is no reason to believe that a similar pattern will not be repeated in Indian stock markets. In any case, the analysis is only to bring out some relevant lessons and not exact figures.
THE MILLENNIAL TABLE44
As far as the Indian stock markets are concerned, beginning 1992 (post liberalisation of Indian economy) there have been three bear market phenomenon: 1992 (56 percent fall, 12 months duration,) 2000 (58 percent fall, 19 months duration) and 2008 (62 percent fall, 13 months duration.) In general, there have been bear market phases every eight years beginning in 1992. However, the recovery has been relatively swift—between 12 and 19 months.
In the long-term, and 100 years data is really long-term, 100 percent equity investments have given the best returns. At the same time, in a bear market, 100 percent equity portfolio has suffered the worst crash (refer serial 1 of table.)
So, an investor with a strong risk appetite should brace herself for a 50-60 percent loss in portfolio value which could last as long as 18 months. Easier said than done. Imagine how you would feel if your retirement portfolio value of ₹50 lakhs became ₹25 lakhs on the year of your retirement.
On the other hand, a totally risk-averse investor who puts all his assets in debt instruments will never suffer a loss, at least a prolonged one. In fact in the bear phase when equity instruments took a beating, his portfolio may give him positive returns (refer serial 21 of table.) This phenomenon is called a ‘perfect negative correlation’ meaning that equity and debt instruments move in opposite directions in different market phases. A word of caution here—there have been bear phases when both equity and debt instruments have taken a plunge together.
The flip side to a 100 percent debt portfolio is that in long-term it has not beaten inflation (6 percent for India.) So effectively your portfolio value has eroded over time.
To beat inflation, the portfolio needs to have at least 30 percent of equity (refer serial 15 of table.) This portfolio design also gave a very marginal loss (-3.51 percent) during bear market. Are we looking at near ideal portfolio mix for an investor nearing or into retirement?
The rule of thumb asset allocation for an early retiree suggests a 40:60 equity to debt mix. If we analyse the performance of this asset mix (refer serial 13 of table), we find inflation-beating returns and a loss of less than 10 percent in bear market. Tolerable for an early retiree? Well, it appears so especially if another source of income is available in form of pension or annuity.
Let us now look at the rule of thumb portfolio mix for Anshreya at the age of 25 years, as she starts earning. A 75:25 portfolio (refer serial 6 of table.) We see a healthy long-term return of nearly 9 percent but a loss of nearly 30 percent. Can Anshreya handle this loss? Yes. She has a long investing life ahead and can certainly wait it out for 18 months (the worst case scenario for Indian markets) to reap the benefits of long-term equity investments.
We are now getting some clarity as to what should be an ideal asset allocation mix. Remember, this is the most important investment decision you will make and it needs to be well-deliberated so as not to change during turbulent market conditions.
How exactly to diversify within different asset classes (diversification) will be tackled in subsequent musings, but before that, we will look at some readymade portfolio designs as suggested by financial masters, which we can use for more nuanced asset allocation vis-a-vis the ‘rule of thumb allocation.’
Key Chapter Takeaways
For a young investor who has plenty of time to recover from a financial downturn, a debt component equal to his age or even 10 percent less than his age is suitable. For Anshreya, at age 25, debt component of her portfolio could be between 15-25 percent. The rest should be in equity.
An equity component of around 30 percent is a must to get inflation-beating returns. Hence, even for a person into retirement, a 30:70 (equity: debt) portfolio is desirable. Being in 100 percent debt is not safe as the value of portfolio will keep eroding over time.
A 100 percent equity portfolio is a recipe for disaster as in a severe bear market, which may persist for up to 36 months (Western markets have suffered such bear phases,) a loss of 50-60 percent of portfolio value may occur. If it coincides with an important life goal like retirement, birth of a child or marriage, it might be a catastrophe. A minimum 25 percent of debt component, except for young investors, is a sine qua non.
For the reasons mentioned above, around 36 months before the life goal is reached, equity component of the portfolio (earmarked for that life goal) must be systematically shifted to debt via systematic transfer plan (STP.) More about it later.
MUSING 17: THE MASTERS ARE CALLING
MODEL ASSET ALLOCATION STRATEGIES
The best part about reading books written by financial gurus was the insight I got into their psyche and their fundamentals about investing. Surprisingly, or maybe not so surprisingly, they were all consistent about a few issues which are listed below:
• Don’t lose money (at least in the long run.)
• Individual stock picking is best avoided.
• The best way to get stock market exposure is through equity mutual funds—preferably index funds.
• Asset allocation and diversification are the most important financial decisions an investor makes.
• Equity investment is for the long-term. But qualifying long-term is a debatable issue. Generally, a time horizon of 5 years can be reasonably construed to be long-term.
• Most recommend a bit of international exposure in the portfolio.
• A suitable debt component is a must for stability of the portfolio.
• Real estate (not REIT) is not a good investment. We have already discussed this issue earlier.
• Gold also is not a good investment. At best some part of portfolio could be kept in gold as a hedge against inflation or market downturn.
Having revised these investment mantras (these are worth their weight in gold—not literally though,) let me now give you an insight into the suggested portfolio designs as given by the financial masters. I will first give a bit of background of the master followed by his suggested portfolio design. Most of these portfolios have been taken from Tony Robbins book ‘Money— Master the Game.’
David Swensen: Swensen is the chief investment officer of Yale University who grew its endowment from $1 billion to more than $23.9 billion in less than two decades.
Serial Investment Percentage
1 U.S. Total Stock index 20 percent
2 Developed(foreign) markets index 20 percent
3 U.S. REIT index (real estate) 20 percent
4 Long-term U.S. Treasuries index 15 percent
5 U.S. TIPS index (Treasury inflation-protected) 15 percent
6 Emerging Markets Stock index 10 percent
• The complete portfolio is in index funds (more about them later) with the equity component of 50 percent divided into domestic (U.S.) market index, developed and emerging markets index. Thus the portfolio has 30 percent equity exposure in global funds.
• Debt or fixed income component accounts for 30 percent of portfolio split between long-term US Treasuries and TIPS.
• Real estate accounts for 20 percent of portfolio but in the form of REIT.
Burton Malkiel: I have quoted his iconic book, ‘A Random Walk Down Wall Street’ repeatedly in this book.
Serial Investment Percentage
1 US Total Bond index 33 percent
2 US Total Stock index 27 percent
3 Developed (foreign) market index 14 percent
4 Emerging Markets Stock index 14 percent
5 US REIT index (real estate) 12 percent
• Like Swensen, the complete portfolio is in index funds.
• Equities comprise 55 percent of portfolio split between US domestic market, developed and emerging markets. The global exposure is 28 percent.
• Debt component is 33 percent in
form of US total bond index fund.
• Real estate accounts for 12 percent of portfolio in form of REIT.
John Bogle: An investment legend whose book, ‘Common sense on Mutual Funds’ I have repeatedly quoted. He is the founder of Vanguard and the inventor of index funds. Like his book, his model portfolio is also pretty straightforward.
Serial Investment Percentage
1 US Total Stock index 65 percent
2 Intermediate-term US Total Bond index 35 percent
• Simplicity is the hallmark of Bogle’s model portfolio. The equity vs. debt ratio is 65:35 (all index funds.)
• If we refer back to our table of millennial returns (1901-2000) of previous musing and look at serial 8, we can assess this portfolio’s best and the worst performance over very long-term.
Dave Ramsey: A motivational speaker and financial guru whose book, ‘The Complete Guide to Money’ I have quoted repeatedly. His ‘Seven Baby Steps’ (to financial freedom) is a must-read and watch. I have provided the link to his video in the musing on ‘debt management.’ Go ahead and watch it, if not already done so.
Dave keeps his model portfolio as simple as his advice to dump debt through his baby steps. He advises to divide the portfolio in four parts and invest each part in large-cap, mid-cap, small-cap and global and international mutual funds. Yes, that simple, but at times it is the simplicity that works better over complexity.
Three Fund Portfolio: This is not the name of a financial guru but a concept of investing which is popularised by all major fund houses, at least in mature financial markets. In the U.S. it consists of just three funds: US stock total market index, US bond total market index and international total market index. This simple funds mix has given better returns than most active and index funds.
Ray Dalio: Dalio is one of the 100 wealthiest persons on earth as on Jan 2018 as per ‘Bloomberg Billionaire index.’ He is the founder and majority owner of Bridgewater Associates, a hedge fund that manages over $160 billion in assets. His model portfolio is supposed to be so good that Tony Robbins in his book, ‘Money—Master the Game’ has called it the ‘All weather Portfolio.’
Serial Investment Percentage
1 US Stock Index Fund 30 percent
2 Intermediate-Term (7-10 years Treasuries) government Bond 15 percent
3 Long-Term (20-25 years Treasuries) government bond 40 percent
4 Gold 7.5 percent
5 Commodities 7.5 percent
• Notice that Dalio’s portfolio has only 30 percent equity component and 55 percent of debt component. His rationale, “Stocks are three times more risky (volatile) than bonds. If you have a 50:50 portfolio, you really have more like 95 percent of your risk in stocks. Thus, you have to divide your money based on risk/reward and not in equal amounts of dollars in each type of investment45.”
• The 30 percent equity component is strikingly similar to the one quoted by Thomas J Stanley and William D Danko in their iconic book ‘The Millionaire Next Door’ in which they state, “Not at any time during the past thirty years have I found that the typical millionaire had more than 30 percent of his wealth invested in publicly traded stocks. More often it is in the low-to-mid-20 percent range46.”
• Also noticeable is the presence of gold and commodities in Dalio’s portfolio which is not there in any other portfolio. Dalio explains this as a hedge against inflation when both equity and debt instruments may give lower returns.
William J Bernstein: The author of ‘The Four Pillars of Investing’ who I have quoted extensively, is a great proponent of MPT and indexing approach. His model of asset allocation is very interesting and is based on one’s tolerance level of risk47.
I can tolerate losing percent of my portfolio in the course of earning high returns Percentage of my portfolio invested in stocks
35 percent 80 percent
30 percent 70 percent
25 percent 60 percent
20 percent 50 percent
15 percent 40 percent
10 percent 30 percent
05 percent 20 percent
00 percent 10 percent
Well, that was a roundup of the model portfolios as suggested by the global financial gurus. They are individuals of great repute and integrity who are known for their sagacity and perspicacity. We, as common investor, would do well to internalise these precepts when we plan our personal finance and investments.
GETTING TO THE BRASSTACKS
MUSING 18: INVESTING IN REAL ESTATE
Buying a House
A house evokes warm and happy memories in all of us, the carefree days of our childhood, the games, banter and the family meals, watching TV together—the geography of each and every nook and corner of the house remains vivid in our imagination. The topic of this musing thus is very important to internalise, especially as buying a house is likely to be the most enduring and financially taxing commitment one will undertake. The decision to go for a house will depend on two things: one, do you need the house and two can you afford it? Let’s tackle both one by one.
In the initial stages of one’s career, frequent movements, either in search of a better job or due to postings or transfers, are inevitable resulting in shifting bases from city to city. If this is the case, it does not make sense to take on the burden of a house in a city from where one will eventually relocate. Remember, looking after the house is a heavy commitment which is difficult to fulfil from a distance. For transitory stay at a place, it is best to rent an appropriate house which should fit within the needs bucket (50 percent bucket).
Pressure will come on you to buy a house at your native place the moment you start earning, with advice like—“the earlier you buy a house, the earlier you can finish paying for it.” Don’t fall for this as, by the time you are ready to settle down after retirement, which may be 3-4 decades away, you may find your native place unsuitable to stay for a variety of reasons. You will be saddled to dispose of this old house to buy one at your intended place of stay. In any case, looking after the house for 3-4 decades including periodic maintenance and tenant management will consume a lot of your time and effort, other than tying down precious financial resources while paying the EMI. It is best to buy the house slightly later in life when you are reasonably sure of finally settling down at a particular place. In general, buying property (rental or commercial) for the purpose of investment is a lousy proposition.
If the conditions mentioned above are fulfilled, you are ready to consider buying a house. A checklist before you take the plunge is given below:
Your breathing fund, as mentioned in musing 6, equivalent to six months of expenses must be built up.
You should have saved up to 20 percent of the cost of the house, to be given as down payment (this is over and above the breathing fund.) So, the loan amount should not be more than 80 percent of the house cost (inclusive of registration and other allied expenditure.) How do you save this amount? Easy, 50 percent of the ‘save’ bucket (20 percent bucket,) could be saved towards the down payment of the house. The moment you give this down payment, this 10 percent saving reverts for other purposes like children’s’ education and retirement.
How much mortgage one can take will be a very important question to ask? The answer is, “If you are not yet wealthy but want to be someday, never purchase a home that requires a mortgage that is more than twice your household’s total annual realised income48.” So, Anshreya with a total realised annual income of ₹6 lakhs (₹50,000 per month) should not be looking at a mortgage amount more than ₹12 lakhs.
The EMI for the house should not be more than 25 percent of your take-home pay. For Anshreya, it should be maximum ₹12,500. A large EMI towards house may make you ‘house poor;’ as you will scrounge from other buckets. Remember, the banks are willing to give you a loan which may be beyond your capacity to pay.
The mortgage period should be 15 years, preferably at a fixed rate of interest. The tendency to go for longer duration mortgages as it brings down th
e EMI must be avoided. You end up paying a fortune to the bank, Google it and you will find calculations of the same.
You have no other pending debts to be paid like car loan or personal loan. If that is the case, first clear off these debts.
Buying a house gives you tax advantage as the amount you are paying towards principal and interest payment gets deducted from your taxable income, subject to few caveats. We will not cover the exact details here but do educate yourself about these tax breaks as they make house loan a good debt.
Finally, as one fulfils other obligations in life and gets an income raise, do consider paying off the house loan earlier than the original tenure of 15 years. It remains, after all, a debt. Don’t continue a house loan merely for the purpose of tax saving. It’s not wise to pay ₹10,000 to the bank on interest payment to save ₹3,000 in tax.
Buying Second House as Investment
Owning a cottage in a hill station where one could go for weekends or holiday retreat or settle down after retirement is a very tempting and alluring thought we all get. Fantastic idea, but can you afford it? Remember, the property remains vacant and hence earns you no income. It requires regular investment in the form of maintenance and upkeep charges which results in further opportunity cost. On top of it, if you have taken a loan for this property, the EMI drains you. “If your house is your largest investment, you are in trouble49.”
Similarly, buying a second home in a big city for giving it on rent to earn rental income is an idea that occurs to many of us. The problem is that in big cities, there is a saturation of houses which lie vacant and await tenants. The second problem is that one might get stuck with unscrupulous builders who will not deliver the house on the promised date or even year. The third problem is getting stuck with a difficult tenant who does not pay rent in time or refuses to vacate the house when you want him to.
