In a take-off or landing, the pilot smoothly changes the speed and the incline of the flight to avoid mishaps.
Similarly, while building portfolios for retirement and other financial goals, financial advisors might need to tweak asset allocations over the course of an investor’s journey to ensure their goals are met without setbacks.
Asset allocation is an important contributor to investment portfolio returns. However, it need not necessarily be a static one.
It is important to set the context of how your asset allocation would look now and in the future and that’s where the glided path approach plays an important role.
What is a glide path in relation to investments?
A glide path refers to changes over time in the spread of money in a portfolio across different asset classes, primarily that of equity, debt and cash.
So equity glide path refers to strategic shifts that one makes in the equity composition of one’s portfolio over a period of time.
How does it work?
Not all asset classes carry the same level of risk. Equities while holding the potential for maximizing returns is also volatile over the short term. Bonds in turn are relatively safer while also yielding moderate returns to their investors.
So, investors need to shift asset allocation over time in a way that balances risk vis-à-vis returns and achieves their investment objectives. By doing this, investors also avoid sequence risk – the danger of timing of the withdrawals affecting the investor’s return.
There are three types to the equity glided path:
Declining equity glide path
In this approach, one gradually reduces the component of equities in a portfolio and on nearing goal achievement. It is a popular retirement investment strategy.
A 30-year old retiring at 60 years has an investment horizon of 30 years. And such a long period of time gives her the elbow room to take higher exposure to equity and even out any interim volatility.
So, typically she starts with 80-100% equity exposure. However, on reaching her 50s, the equity component is gradually scaled down to say 40-50% of the portfolio by the time of retirement.
This is done systematically by selling equities every year and reinvesting them in more stable instruments like bonds.
Static equity path
In a static equity path, you maintain a specific asset allocation throughout the investment journey. On retirement, financial advisors advise investors to maintain up to 50% in equities to combat longevity risk and elongate the life of your portfolio by a few more years.
Typically, it is done by keeping equity exposure constant for the initial 10-15 years and later scaling it down. It can be a gradual shift or a steeper curve at the fag end (in order to safeguard your portfolio). The exact quantum of shift depends on many factors including your financial situation.
Sometimes, ESOPs become a big chunk of one’s investment portfolio. Over a period of time, you might want to diversify your equity holdings while keeping the equity mix constant.
Rising equity path
In some cases, the equity component also needs to be gradually increased. Say an investor has an existing bond portfolio that will mature over the next 5 years. And he wants to increase the equity portfolio. So, he would gradually shift the debt portfolio by reinvesting in equity while also making additional investments along the way.
But there’s some fine print as well
The conventional and simplistic view of investment glide paths ignores the significant role that sub-asset classes play in calibrating risk and opportunity on the way to one’s retirement or other goals.
Equity and fixed income come in many flavours; in equity, you have large-cap, mid-cap and small-cap. And in fixed income, you have debt funds with varying durations or based on types of underlying bonds and instruments.
So, while tweaking asset allocations and derisking, for instance, investors should also ensure the underlying asset class under the hood of the glide path shifts accordingly.
Similarly, allocation to alternative assets can also offset the correlation between primary asset classes by providing risk mitigation in times of a downturn.
A glide path with relation to equity is a popular strategy to shift asset allocation over time in a way that balances risk vis-à-vis portfolio growth and achieves one’s investment objectives. Use it to smoothen your investment journey.