Tackle volatility to reach investment goals smoothly

Short-term price volatility can adversely affect an investor's liquidity needs.

Since the beginning of 2011, the Nifty Index has fallen from a high of 6,181 to a low of 4,720. This drawdown does not capture the high volatility that the market has witnessed during the period. Volatility is rewarding when asset prices move upwards, but not when prices swing up and down. For, the investor is then faced with a choice: Is it good to take losses and reduce equity exposure? Or is it optimal to hold the position? The choice is not easy, but the decision is important for achieving an investment objective.

This article explains the importance of goal setting. It then discusses how goal setting can help investors moderate the impact of price volatility on their portfolio and enhance their chances of meeting their investment objectives.

Liquidity risk

Individuals typically invest to generate returns. Without any particular goal, such a portfolio would carry some proportion of bonds and equity. Cash is held in the portfolio primarily to buy these assets. This no-clear-objective portfolio faces high liquidity risk. This risk has two components- marketability and volatility.

An actively traded stock such as Reliance Industries is marketable because the cost of finding counterparty is low. The same cannot be said of, say, Electrotherm India. One indicator of high marketability is a low bid-ask spread.

Next, consider volatility. Suppose an individual wants to pay Rs 31 lakh as down payment towards purchase of a house in 2013. Assume that the individual invests Rs 25 lakh in an index fund in 2011 and that the investment is worth Rs 33 lakh in 2013. The investor can no doubt make the down payment. But she may be forced to sell the investment at a price that is significantly lower than the year's high. The impact of such fire-sale will be visible when the Nifty Index moves up in value after the individual has withdrawn the necessary cash. This happens because the individual did not envisage the impact of volatility on her liquidity needs.

Wealth mapping prompts an individual to map her investments to the desired objectives. But not before the individual sets aside enough money to take care of her short-term needs. It is this process that help individuals weather the market volatility.

Liquidity needs

An individual's lifecycle needs can be divided into protective assets, lifestyle assets and aspiration assets. Protective assets essentially help an individual protect her basic standard of living. Lifestyle assets take care of intermediate objectives such as buying a house and meeting children's education costs. Aspiration assets help an individual significantly enhance her standard of living.

Now, market volatility affects lifestyle assets the most, especially those investments that have short-term objectives. One way to moderate this effect is to move investments into protective assets based on a pre-defined rule.

Consider a five-year investment to make down payment for a house. Such an investment would be in stocks and bonds as part of lifestyle assets. Suppose the expected return on the investment is 15 per cent per annum. If the investment earns returns in excess of 15 per cent in any year, the individual should move the excess returns to money market funds within the protective assets. This process will help the investor lock-in the excess returns and cushion any shortfall due to high volatility in later years.

Besides, an investor should ideally keep investment less than three years inside the protective assets to moderate the impact of price volatility. Such investments would, however, expose an individual to shortfall risk, as money market funds generate low returns. An optimal alternative would be to gradually move an investment from lifestyle assets to protective assets as it approaches the horizon date.

Conclusion

High volatility primarily affects short-term objectives within the lifestyle assets. Investors can adopt a glide path to move investments with less than three years maturity from lifestyle assets to protective assets, just the same way a target-date fund moves investment from equity to bonds as it approaches the target retirement date. This process could balance liquidity and shortfall risks and enable individuals' weather turbulent market conditions.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. He can be reached at >enhancek@gmail.com)

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