You may want to cut your equity allocation to reduce the risk of investment loss as you near the end of the investment horizon for a life goal. But how do you decide how much of your equity investment to cut? We discuss the principles you should apply to cut your equity risk as the distance to investment horizon reduces. As you will see, the equity risk you hold in your portfolio is a function of your goal priority.

Glide path

The term glide path typically refers to how your equity allocation will change during your working life in your retirement account. We use the term in a much broader sense. Glide path refers to the change in equity allocation in any of your investment accounts, including your retirement account and your child’s education portfolio.

Glide path is an integral part of the portfolio management process for two reasons. One, your willingness to take risk declines with age. And two, shorter the time horizon for your life goal, lower is the portfolio’s ability to bear risk. Why? Suppose your goal is to buy a house four years hence. To this end, you create a portfolio with equity and bonds. What if the stock market declines sharply in the second year of your investment? You hardly have the chance to recover the losses before year four.

The reason is do with asymmetric returns effect. It refers to the fact that it takes a lot of effort to recover unrealised losses but it takes little effort to give-up unrealised gains of the same magnitude! For example, unrealised loss of 50 per cent in your portfolio could need a 100 per cent increase in prices to recover the losses. Whereas unrealised gain of 50 per cent just needs 33 per cent decline in prices to wipe out the gains!

To protect your portfolio from asymmetric returns effect, you should cut your equity allocation as the distance to investment horizon for a life goal reduces.

Goal priority

The question then is: Should you bring your equity allocation to zero? The answer depends on your goal priorities. It is generally better to have only bonds in your portfolio when you have a life goal with an investment horizon of five years or less. This is because five years is a typical market cycle. Also, it takes that much time for your portfolio to heal after large losses.

Extending this logic, you should have minimal equity exposure when the distance to investment horizon for a life goal reduces to five years. Suppose you wish to buy a vacation home in 2027. You may create a portfolio with 60 per cent equity and 40 per cent bonds today. But you should reduce your equity allocation to, say, 30 per cent by 2022. This helps you reduce the asymmetric returns effect that your portfolio is exposed to. Yet, it allows your portfolio to earn higher returns to accumulate the wealth required to meet your life goal; for expected return on equity is higher than expected return on bonds.

There is one exception to this argument. What if the life goal you are pursuing is very important? Suppose you are saving money for your daughter’s college education in 2027. You may do well to shift your entire portfolio to bonds by 2022-23. Why? A high-priority goal has low risk tolerance.

This means you cannot absorb shortfall in your child’s education portfolio, as this goal cannot be postponed. So, you should consider shifting to an all-bond portfolio when the distance to horizon is five years.

As a general rule, bring your equity allocation to zero for high-priority goals when the distance to investment horizon reduces to five years.

For all other goals, consider reducing your equity exposure to about 30 per cent.

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

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