In an earlier post The Essence Of Equity, I had mentioned that the equity allocation for long term goals must not exceed 60%. I had also said that I would be doing a separate post in the future covering the reasons behind the statement. And here is that post. I will show why it makes sense for most investors to limit equity exposure to 60% in portfolios for long term goals.
Theoretical finance postulates that investors in their early or mid 20s with an aggressive risk profile can allocate more than 60% of portfolios for long term goals to equity. But this need not necessarily be true. Let us first understand what an individual's risk profile comprises of. Any individual's risk profile is built on two aspects. These are risk capacity and risk tolerance.
Risk capacity shows how much risk the an individual can afford to take. The major factors that affect an individual's risk capacity are given in the graphic that follows.
Risk tolerance shows how much risk an individual is willing to take. The major factors that impact risk tolerance are given in the graphic that follows.
Individuals with the capacity to take a high degree of risk and the willingness to tolerate it are said to have an aggressive risk profile. It is firstly very hard to define the term 'high degree of risk'. The term is subjective in its very nature. But let us ignore this fact for the purpose of this discussion. To have a purely aggressive risk profile an individual must essentially be young (say below age 35), and also satisfy every single one of the conditions given in the graphic that follows.
Most individuals would be able to satisfy some or most of these conditions. But no individual would practically satisfy every single one of these conditions. Therefore it is near impossible for one to have a purely aggressive risk profile. This means that running long term portfolios with an allocation of more than 60% to equity would not be viable for most individuals.
A more mature way to define risk profiles would be to say that all individuals would start with a largely balanced risk profile. Each individual may then have a slight preference for aggression or prudence. This preference is unique and varies from one individual to another. A long term portfolio with a 60:40 allocation to equity and debt would have something on offer for all individuals.
Those with a preference for aggression would be satisfied with the fact that the lion's share of their portfolio is allocated to risky, growth oriented assets. Those who prefer prudence would find comfort because almost half of their portfolio is allocated to stable, relatively less volatile assets. They would therefore be exposed to just as much risk as is required.
This covers the conceptual reasons as to why a 60% equity allocation is ideal for long term portfolios. Let us now look at the technical reasons. The technical reasons have a lot to do with portfolio risk. Studying the behaviour of equity as an asset class would reveal an interesting observation.
A portfolio with a 60% equity allocation would carry the risk of a maximum drawdown of 35-40% of the overall portfolio (equity + debt). The maximum drawdown for various equity allocations is given in the graphic that follows.
Therefore any given level of equity exposure is riskier than it is on paper. Such a degree of risk is too much for most individuals to comfortably bear. This is similar to the Real Feel feature in weather apps. The weather on a particular day may feel hotter or colder than it is on paper.
There is another point here that is worth noting. As the equity allocation in a portfolio increases, so does the time taken by the portfolio to recover from a drawdown. Portfolios with a 60% allocation to equity usually take between 1.5 and 2 years to recover after a drawdown. Portfolios with a 70% or 80% allocation to equity usually take between 2.5 and 3 years to recover after a drawdown.
During such periods portfolios remain largely stagnant and go nowhere. Such periods of stagnancy may be too hard for individuals to deal with psychologically. This reduces one's chances of being able to live with significant equity allocations over substantial periods of time. This defeats the purpose of operating with a disproportionately high equity allocation. I trust that these are reasons enough to drive home the central point that an equity allocation of upto 60% is optimal for long term portfolios.
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