Portfolio Ideas. Cushion equity risk with income-earning assets

In the name of diversification, you invest in multiple asset classes such as equity and bonds. You reason that bonds and equity do not fall together. So, equity price declines can be cushioned by bond investments.

In other words, you are implicitly depending on low correlation between equity and bonds to reduce portfolio risk. In this article, we discuss how we can use volatility as a factor to cushion the adverse impact of equity exposure on your goal-based portfolios.

You may be pursuing multiple life goals such as buying a house or funding your child’s college education. All these life goals require you to invest in equity. And with equity comes volatility.

We refer to volatility as the tendency of an asset to deviate from its expected returns. Suppose you invest in an equity mutual fund hoping to generate 12 per cent return per annum. But the fund generates 10 per cent, 11 per cent and 14 per cent in the next three years. The deviation in yearly returns from the expected returns is the fund’s volatility. Such volatility is not good for your goal-based portfolio. Why?

Your monthly savings have to earn a minimum compounded annual return to accumulate the wealth that you need to achieve each life goal. Volatility could lead to failure in achieving your investment objectives. Here is how.

Suppose you need 10 per cent compounded annual return to achieve a goal. Suppose your portfolio earns only 8 per cent in the first year and 8.5 per cent in the second. Your portfolio has to earn about 13.5 per cent in the third year just to “catch up” with the expected return of 10 per cent per annum. Note that notional loss has the same impact on your portfolio as actual loss. So, what should you do to reduce the impact of equity volatility on your portfolio?

You should invest in products that are not affected by equity price volatility. We call such products volatility non-conductors.

What are these products? If you are a working professional, you should invest in income-earning assets. The most popular among them is bank fixed deposits. You can also buy tax-free bonds, and hold them till maturity. Investing in provident fund and public provident fund will also help.

As these assets provide only income returns, they are largely unaffected by the normal stock price volatility.

If you are a retiree holding equity investments, your primary choice should be monthly-income bank deposits. And then, there is real estate investment. Rental income is largely unaffected by stock price volatility.

There is another category of investments we call as pseudo non-conductors. These investments are actually volatile, but the price volatility is not visible. So, it appears that such investments are not volatile.

Investing in these assets will not really reduce your risk of failing to achieve your life goals. But it does offer emotional satisfaction and generates less fear when equity prices go down. Three such assets are passion assets, gold ornaments, and land.

Passion assets are assets that you collect such as paintings and antiques that also have investment value.

Typically, volatility non-conductors are assets that earn income returns, and are not traded. This is different from selecting assets based on correlation. How? Implicitly using correlation, you will combine traded commodities and bond funds with equity to lower portfolio risk.

The issue is that weakly correlated assets become strongly correlated during unexpected market conditions. So, your bond funds and traded commodities could lose value along with your equity investments.

However, combining income-earning assets with equity does not typically have such effect; for actual returns will largely be the same as expected returns, stabilising your goal-based portfolio’s cash flows.

The author is the founder of Navera Consulting. Feedback may be sent to portfolioideas@thehindu.co.in