It may not be enough to diversify your investments, especially if you believe that equity markets can decline sharply when you are closer to the end of the time horizon for a life goal. In this article, we look at alternatives to help moderate the risk associated with your goal-based portfolios.
Likelihood and magnitude
Diversification, if done appropriately, may suffice if the magnitude of the market decline is small and there is a low likelihood of the decline happening closer to the end of the time horizon for your life goal. Why? Diversification reduces the risk that a company-specific or sector-specific negative event does not hurt your investment returns. It is not meant to protect your portfolio from a decline in the equity market.
What if the likelihood of an equity market decline is low but the magnitude of the decline is expected to be high? You cannot recover unrealised losses or the loss of unrealised gains in time to achieve your goal. Why? For one, your equity investment must earn a required return to achieve your goal.
A decline in market means that the investment has failed to achieve the required return. For another, your equity investment must preserve its already-accumulated unrealised gains to achieve the goal; a market decline could lead to giving-up those gains. It is difficult to bridge the resultant shortfall in a short period, say three to four years.
In such cases, buying an insurance is an optimal choice, for insurance is supposed to mitigate risk arising from low likelihood, high magnitude event. But you cannot buy an insurance to protect the downside risk associated with your investments. So, you must self-insure to moderate this risk. That is, you must be willing to transfer funds from a longer-horizon goal-based investment such as your retirement portfolio in the event the market declines and you face a shortfall in your near-term goal.
Conclusion
The biggest issue with equity investments is when the magnitude of the decline could be significant, and the likelihood of the decline is high. You must then consider a two-step process to moderate the risk. First, substantially reduce equity investments in your portfolio and move the proceeds to cumulative fixed deposits that mature at the end of the time horizon for your life goal. And second, increase your savings and set up a new recurring deposit to bridge the shortfall that will arise from lower expected return because of transferring investments from equity to bonds.
(The author offers training programmes for individuals to manage their personal investments)
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