Protecting one’s capital is an important consideration while constructing an investment portfolio. This in turn has implications for portfolio choices. The conservative investor may prefer a debt-laden portfolio, which is less susceptible to market fluctuations.
But what about the risk that emanates from the different phases of saving and investment? Essentially, when and how does an investor de-risk his investment portfolio?
What life stage?
First of all, the investor needs to check his or her life stage.
There are three life stages from an economic perspective – Accumulation, Preservation and Distribution phase. In the accumulation phase, as the name suggests, the investor is young (20s, 30s or the 40s) and saves more and more from his improving income levels. Equities need an investment horizon of at least seven years and for these ‘accumulators’, retirement is at least a decade or more away. They have the leeway to take higher exposure to equity. De-risking is a low priority for them.
However, those in the preservation phase should gradually start de-risking their portfolio since the drawdown period is nearing. Typically, those in their 50s should consider reducing equity exposures in a phased manner as they near retirement.
Finally, in the distribution phase, one start’s depending on his wealth for providing regular income – say after retirement. Ideally, by then the portfolio should carry less risk – lest it gets affected by market volatility. So, the focus is more on looking towards the stability of income while also working towards beating inflation.
How far away is your Goal?
The goal could be for retirement, buying a house or children’s higher education. The basic approach is that once you near your goal, you should start de-risking your portfolio. The logic is simple. Imagine a situation where you are close to your target portfolio and then the equity market crashes. An equity-laden portfolio would see a significant reduction and delay your goal achievement.
Historically speaking, equities have given inflation beating growth over 6 year periods or longer. So, as long as you have an investment horizon of at least 6-7 years, consider equity funds. If not, invest in debt that grows much slower but provides better security and stability of capital.
Here are the different ways to de-risk your portfolio:
1. Tweak asset allocation
One of the popular ways to de-risk an investment portfolio is by changing the asset allocation in favour of debt. So, you sell equity funds and reinvest it into debt funds, thereby changing the asset mix. While such rebalancing helps you hit your target asset allocation mix, it also has tax implications. Capital gains over and above Rs 1 lakh in a year could attract taxes at 10% for equity funds.
2. Divert new investments
However, if you want to avoid/defer such taxes, you could route new incremental investments into debt funds to reduce the overall equity exposure. For this strategy to work, however, it is important that the new investments are relatively proportional to the shift you want to see.
3. Intra-asset shuffle
Alternatively, you can also change the portfolio composition within an asset class. For instance, within equities, there are large-cap, midcap and small-cap funds. Shifting assets from small-cap towards midcap or from midcap towards large-cap funds reduce the overall risk measure. Similarly, you can cut back exposure to long and medium-term debt and increase investments in short-term and ultra-short-term debt funds.
While de-risking might be necessary, ensure you don’t do it in a flash; it could otherwise expose your portfolio to market volatility. Rather start withdrawing from equity (or investing in debt) in a systematic way as you start nearing your goals. In the case of retirement, you can continue to have exposure to equity after retiring as long as you don’t need that part of the money for the next seven years.
De-risk your portfolio based on your life stage and the investment horizon. While doing so, ensure it is done gradually and in a tax-efficient way.