All of us have various strategies when it comes to investing. Whether we follow a complex tactical approach or a more simple, systematic approach to our investing there is one factor that significantly influences our investment strategies. That being the overall context and conditions that prevail in the financial markets at a given point of time. All of us constantly try to adapt and orient our investment strategies to keep up with the changes in market conditions. And this leads to a lack of discipline in our approach which ultimately sees us perform a lot worse than we actually could have.
But there is actually an investment strategy that is extremely simple, can be followed by everyone and takes the effects of prevailing market conditions out of the picture.
The nuances of this strategy are also very easy to understand and adopt. It is specifically meant for goal based investing. And once the strategy is in place it allows us to pretty much put our investing into autopilot, apart from minimal effort required for periodic review and rebalancing of the portfolio. So today I will discuss the steps involved in adopting this strategy and show how and why it works well regardless of what markets are doing at a given point of time.
The first thing we need to put this strategy in place is to have clarity on our financial goals and when we require the money for each of them. This helps us segregate our financial goals into short term, intermediate term and long term financial goals. Most of the time we tend to view goals that are due in 5 or more years as long term goals. But this is mostly a misconception. To my common sense long term goals would be those that fall due in a bare minimum of 7 years, and ideally 10 years or more. Any goals which fall due 3 to 5 years should be classified as intermediate term goals. And any goals that fall due in 3 years or less should be classified as short term goals.
Next, we would have to define the initial asset allocation for each of our goals. When picking asset classes for our financial goals, we must allocate the majority of the portfolio to the asset class that provides the most stable and sustainable performance over the tenure of the goal. Accordingly for long term goals which fall due in 7 to 10 years or more, upto 60% of the portfolio can be allocated to equity with the rest going to debt. For intermediate term goals that are due in 5 to 7 years 70 to 80% of the portfolio must go into debt products (both traditional and market linked) with the rest going to equities.
For goals that fall due in less than 5 years, the portfolio must almost entirely be allocated to debt, with minimal to zero allocation towards equities. Of course, returns from such portfolios would naturally be quite low compared to those that have an equity component in them. The only way to compensate for lower returns in such cases would therefore be to increase investments in portfolios for such goals at every given opportunity. Additional investments can come in the form of a scheduled annual increase as per our financial plans, or through the employment of any lumpsum amounts that become available to us.
Once we have set the initial asset allocation for each of our financial goals, we must set realistic long term, post tax return expectations for each asset class in our portfolios. At the present moment it would be reasonable to expect a long term return of 9-10% post tax from equities. As far as debt is concerned, assuming a long term return of about 7% post tax would be realistic at the present moment. But these expectations may have to be revised downwards to between 5% and 6% in the years to come. These estimates would give us an expected long term portfolio return between 8.2% and 8.8% post tax for a 60% equity 40% debt portfolio, which is quite reasonable.
At this point most of us would pick our investment products and initiate our investments. But before doing this, we need to provide for sequence of returns risk in our portfolios. And to do this we would need to have a clear strategy to progressively reduce the equity allocation in our portfolios over the course of the tenure of each of our goals. An interval of 3 to 5 years in two reductions of the equity allocation in a portfolio would be ideal. For instance, take a look at the graphic below, showing how the equity allocation in a retirement portfolio has been reduced from 60% to 10% over a span of 15 years.
Doing this would reduce the impact of a major drawdown in the value of our portfolios, and especially so around the time our goals fall due. For a more in depth understanding of the concept of sequence of returns risk and the process of reducing the equity allocation in a portfolio, have a look at my earlier article Risk In The Sequence. Once we have a strategy in place to progressively reduce the equity allocation in our portfolios, we can pick our preferred investment products (ideally direct growth plans of index funds, liquid funds and 10 year constant maturity government bond funds) and implement the strategy.
From here, an annual review and rebalancing as and when required would be more than enough. Following this strategy means that we would be clear about our financial goals, pick the asset classes that suit our financial goals the best in the right proportions, have realistic expectations from our portfolios, provide a substantial buffer for portfolio drawdowns and ensure that our portfolios are always optimally balanced. And this effectively means that our portfolios would be well placed to deliver stable and sustainable returns, regardless of what the markets are doing.