Why Not 100% Equity?
The risks of a one-dimensional portfolio and free climbing
For three years, I missed the forest for the trees. I was exhilarated by the exceptional performance of a single stock that made up just 4% of my portfolio, while 96% of my money was sitting in fixed-income products (fixed deposits, recurring deposits, EPFs, and the like). It was the performance of this 96% that mattered keeping my overall return capped at around 7-8%.
The answer to my problem was not to flip the numbers and have 96% of my money in stocks. While equity is one of the most accessible ways to build wealth, its performance is volatile. It is essential to improve returns, but you also need a second asset class—fixed-income to balance the risk and withstand volatility.
A portfolio with 100% equity is like free climbing a steep cliff with no ropes.
Imagine a rock climber scaling a mountain, equipped with harnesses and ropes. As she climbs, she pauses every few feet to clip her rope into anchors on the rock. To her, it is almost second nature, from the muscle memory of doing it countless times.
Now, imagine she didn’t have to secure her rope each time. She would probably climb much faster without all that equipment on her. She chooses, willingly, to weigh herself down with ropes, harnesses and clips because she is preparing for the fall. It is not her grip that saves her from a loose rock or a brief moment of inattention. It is the rope she clipped in moments ago, the foresight to prepare for gravity’s indifference.
Equity1 in your portfolio is the rock climber, and fixed-income2, the rope and the anchor. When equity is giving phenomenal returns, it may feel like fixed-income is slowing you down. But just like the climber, our portfolio needs to prepare for the fall. When equity markets drop—as they inevitably do in the short term—fixed income will prevent your portfolio from crashing to the ground. By providing stability it allows us to take on the risk that comes bundled with equity.
A climber wouldn’t go up a rock face without a rope and anchor, and for the same reason, a portfolio shouldn’t be made up of 100% equity without any fixed-income.
The failsafe works only when the anchors are strong enough to hold the climber’s weight if she falls. In the same way, fixed-income returns should remain stable and independent of equity movements. This idea of having investments whose returns do not affect each other is known as having “uncorrelated returns”. Only when asset classes in your portfolio are uncorrelated, you get the true benefit of asset allocation: improving returns while at the same time reducing risk.
Breaking Down Your Portfolio: What Are You Really Holding?
Asset allocation can improve returns and reduce risk, but only if you have the right mix of ingredients in your portfolio. Before creating this mix, you need to recognize the different asset classes hiding inside investment products.
Let’s say you have a large cap mutual fund3 in your portfolio. At first glance, such a fund with a portfolio of 30+ companies might seem well diversified. However, the asset class of all the companies in the fund is still only equity. Their prices move in the same direction and their returns are correlated. Asset allocation is more than just diversification; it means investing in asset classes that respond differently to market conditions.
To know if assets are uncorrelated, we need to learn to identify asset classes. Despite the sheer number and types of financial products available, they are built from just a handful (thankfully) of asset classes. They are:
Most investors need only the top three—Equity, Fixed-Income and Cash—to form a balanced portfolio that can withstand market cycles.
Equity to drive long-term growth
Fixed-Income to provide stability and
Cash to serve short-term liquidity needs.
If one has to deal with just asset classes and choose between them, it would make investing simple for everyone involved. But these asset classes come packaged in financial instruments with varied names. Here are some of the common financial instruments grouped by their asset classes.
All products in the image above invest in a single asset class. It gets trickier when a single product blends multiple asset classes. I personally prefer instruments which invest in just one asset class to avoid this complexity. Hybrid mutual funds, National Pension Scheme and Unit Linked Insurance Plans are products which have a blend of both Equity and Fixed-Income in varying degrees.
The investment products may go by many names: education fund, retirement fund, guaranteed benefit plans, a life insurance plan and so on, but they will all contain one or more of the seven asset classes. Look for the asset classes in the product information, the policy document or question the person selling the instrument to you. It is critical to first identify the ingredient asset classes of any product you invest in. Once you do, ask yourself these three questions,
How much of each asset class do I hold?
Do I have a meaningful equity allocation to drive returns?
Do I have sufficient and stable fixed-income in my portfolio to reduce risk?
Answering these will help you see the big-picture of your portfolio and give clarity on the direction to take from here.
The Key To Staying Invested
Asset allocation is not hopping between asset classes, timing the market and eking out every last % of return. It is also not diversifying and spreading your money between a lot of stocks, funds and products, hoping that at least some of them will work out. It is about building resilience and staying in the game. Like a seasoned climber who uses ropes to prepare for unforeseen slips, we, too, must design a portfolio that lets us climb with confidence. The goal is not how fast you can get to the top, but surviving to make it to the next climb.
How do you know if your equity allocation is meaningful? If your fixed-income allocation is significant and stable? If you are wondering about these questions, drop me a note at malarkodi@quinstinct.com or complete the form below (5 questions) with your context.
I will respond to you within 3 days. Should your situation align with my expertise, I’ll send a link for us to meet online. This is a no obligation meeting on either side.
Read more about me here, and for disclaimers see here.
An equity investment is money that is invested in a company by purchasing shares of that company in the stock market. These shares are typically traded on a stock exchange. Source