Combining conservative floor with risky upside

In this column dated March 25 we discussed about individual risk preferences. Specifically, in a scenario where your investments are not generating the required return, we asked if you would prefer to take marginally more risk on all your investments or a lot more risk on some of your investments.

We received several responses, asking us how to build a portfolio based on such risk exposure. In this article, we discuss the floor-upside approach.

This approach is primarily used in creating a retirement income portfolio, where most of your capital will be invested in conservative assets while some of it will be invested in high-risk assets.

Flooring investments

The floor-upside approach is based on a simple concept. First, you build the retirement income portfolio with conservative investments to cover essential expenses — expenses necessary for sustainable living. The goal is to enable you, the retiree, to generate stable income to maintain your basic standard of living, post-retirement. The remaining capital will be invested in high-risk investments to meet non-essential expenses — expenses that you can forego if your income falls short of expectations.

Conservative investments for this purpose include annuity, bank fixed-deposits and tax-exempt bonds. We also include insurance to help you cover your family's essential expenses due to loss of income. The upside portfolio will typically have exposure to aggressive equity funds and commodities.

Non-retirees can also create target portfolios using the floor-upside approach. Suppose you want to create an education portfolio for your daughter.

You can set up a conservative portfolio consisting of tax-free and tax-exempt bonds to cover the basic tuition fees; if your child is likely to join college in 15 years, you should preferably invest in 15-year bonds.

The rest of the portfolio can be invested in high-risk investments to cover other expenses related to your daughter's college education.

The floor-upside approach is used by many retirement specialists in the US. But the approach has its shortcomings.

MAJOR issues

You should consider two major issues before adopting the floor-upside approach.

One, you should have high initial capital if you expect to achieve your objectives by investing in conservative assets. Suppose you want Rs 1 crore for your child's college education 10 years later.

You should have approximately Rs 42.25 lakh as your initial investment today, assuming you invest in bonds paying 9 per cent cumulative interest! Otherwise, you will have to invest in high-return, high-risk investments to meet your objectives.

Two, when you invest a small proportion of your portfolio in high risk assets, your downside risk on that investment is very high. Suppose your initial capital is Rs 50 lakh. You will then have only Rs 7.75 lakh to invest in the upside portfolio for your child's education. You will, needless to say, take high risk on this portfolio, investing in aggressive equity mutual funds or investing directly in small-and mid-cap stocks. This is one of the reasons why individuals who adopted the floor-upside approach suffered large losses on their upside portfolio during the sub-prime crisis.

Another argument against this approach is that you may want to achieve a certain standard of living, post-retirement. It is moot if you can think in terms of discretionary and non-discretionary expenses. And if do not think in these lines, you will be unable to set-up the floor-upside portfolio.

Conclusion

Despite these shortcomings, there is some rationale in pursuing the floor-upside approach, given the risk preferences of individual investors. You can create a floor using annuity and fixed deposits to cover your essential living expenses. You can then create the upside portfolio with the rest of your investment capital. The floor-upside portfolio works well when two conditions are met, interest rates in the economy are high, and you have enough investment capital to set up the floor!

(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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