Designing the equity component of portfolios is a crucial exercise. The way the equity component is designed dictates how effective the broader portfolio would be. Therefore it is essential for us to understand how an the equity component of a portfolio can be constructed. The essential prerequisite for this is to understand the nature of equity as an asset class. Therefore today I am going to talk about the what, why, how, and when of equity as an asset class.
It is important to first understand that equity is an asset class that carries a significant degree of inherent risk. This is because equity essentially represents business ownership. In other words investing in equity is equivalent to investing in businesses. Therefore equity exposure must be taken after much forethought. Also, those who run their own business may not need significant exposure to market linked equity in their portfolio. This is because the business they own can be considered as a part of their equity component.
We must next understand the essential reason why equity is included in a portfolio. The fundamental reason behind including equity is to capture real economic growth. In other words the equity component in a portfolio must capture the economic growth of the country where the investor lives. This ensures that the investor's money maintains its purchasing power over time. As a result the investor's ability to consume remains unaffected.
Then there is the subject of international exposure in the equity portfolio. International exposure has its own benefits. These are laid out in the graphic below.
But the core basis of investment is consumption. In other words, the reason we invest for our various goals today is to be able to consume when our goals fall due. A few examples of this fact are laid out in the graphic that follows.
Say for example that an investor plans to live in India for the next 20 years. This means most of their future consumption is likely to happen in India. Therefore the investor must primarily invest in Indian equity instruments. It is only when some part of an investor’s consumption is likely to happen overseas should international equity be considered. Where international equity is included, exposure must not exceed 10-15% of the value of the equity portfolio.
Now comes the question of when to include equity. Equity exposure must only be considered for goals that are more than 5 years away from falling due. The standard deviation of equity returns over periods upto five years is very high. This means that expected returns from equity would have a very broad range over such periods. This unpredictability renders taking equity exposure over periods upto 5 years imprudent. I would even go as far as to say that equity must not be considered for goals upto 7 years away. For goals 8 or more years away, not more than 60% of the portfolio for the goal may be invested in equity (I will release a separate article on why equity exposure must not exceed 60% in the near future). Also the equity allocation in the portfolio must be gradually reduced as the goal comes closer to falling due.
Next comes the exercise of structuring the equity portfolio. Building an equity portfolio with pure large cap exposure is the best way to go about the exercise. This would be enough for most investors to achieve their financial goals. Investors who desire a better risk adjusted return may consider allocating 20% - 50% of their equity portfolios to the mid cap space. Small caps are extremely dangerous. They are akin to double edged swords. They offer exponential returns when they do well. But they are perfectly capable of destroying wealth when they go through a bear cycle. They therefore should not be considered unless the investor has shown the capability to remain disciplined and unaffected across multiple market cycles.
The final question is that of product choices for an equity portfolio. The best way for most investors to build a portfolio today is to simply stick to index funds. A single Nifty 50 index fund is sufficient for large cap exposure in the portfolio. A single Nifty Next 50 index fund is sufficient for mid cap exposure in the portfolio. An illustrative example of the structure of an equity portfolio is given in the graphic that follows.
This approach would keep the portfolio product light, offer diversified exposure and keep investment costs low. Keeping these pointers in mind would allow us to build an effective equity portfolio, staying true to the essence of equity as an asset class.
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