Why Having Fixed Income is Important for Portfolio Goals

The best portfolio strategy for an individual investor is to start by setting a prudent desired asset allocation between risky equity assets and fixed income that the investor is comfortable with and is sustainable, and implementing it by a continuous timely re-balancing of the portfolio. This would mean selling a certain percentage of the equity part when equities have done well, and buying the equivalent fixed income part, thereby resetting the asset allocation to the desired level, and vice versa.

fixedbondsstocksOne of the requirements of implementing this strategy is to have substantial holding of the portfolio (50% to start with) in fixed income or debt funds. Unless one has that holding, it is not possible for the investor to take advantage of low market levels with timely re-balancing. One of the chief advantages of this strategy is not purely mathematical or higher returns, but psychological – related to the mental stability that the average individual investor will experience in the face of falling markets. And if he is in that state, it is likely that he will not only continue investing, but if he has the temperament and discipline, he will also shift fixed income instruments to equity at a time when market levels are low – thus enhancing long-term portfolio returns. This strategy of holding fixed income to some extent when equities are going through the roof also will give him the ammunition to do the right kind of re-balancing when equities tank, and will ensure that like other investors hurt in the crash, he will not run away from the market.

But that also means that when equities are running high, the investor has to be content (and can get a bit impatient) with lower returns due to the debt component. This will take considerable will power and temperamental maturity to stick to, even for the most disciplined individual investors – at least in the initial years of their experience.

So does fixed income play a role or is it only for fuddy-duddy’s to hold? That is a question best answered by the investor himself. But in my experience it does play a role – though that role diminishes as the equity portion of the portfolio increases specially after the investor has seen a couple of economic cycles. So the best path may be to start with an ideal, conservative allocation of 50:50 in the initial few years of investing. The investor will inevitably face the mentally tough situations of large market falls, and get tested. In such situations, the investor is likely to experience and observe his own behavior – whether he falls prey to market vagaries by selling his equity holdings, and stopping further equity investments; or whether he focuses on his asset allocation and shifts some of his debt holdings to equity to re-balance, thus taking advantage of lower market levels. Similarly, he is also likely to go through easier, seemingly feel-rich market situations when equities go through the roof, and see for himself whether he has the mental orientation to sell equities and shift to debt, or ends up going with the crowd increasing his equity exposure.

After having gone through a few such situations in the initial few years, the role that debt funds play in an individual investor’s portfolio is likely to be self-evident. In case he is actually investing regularly with increasing income levels with time, and has gone through a couple of market cycles, it may then be prudent for such an investor to progressively reduce the percentage allocation to debt. Simply because he is confident that he can handle market volatility easily, and secondly because, his portfolio is likely to have reached a size where the effects of re-balancing will likely give diminishing returns.

So yes – debt funds or other fixed income instruments do play a definite role throughout an individual investor’s lifetime. It plays a larger role in the initial years when the effect of asset allocation and re-balancing need to be proven and seen by the investor himself. Unless an investor has fixed income investments, it is not possible to take advantage of market falls by making tactical shifts to equity – thus losing out on long-term portfolio returns. Beyond the first few years, fixed income will still play a similar role where it acts as an income earning store of booked past profits, as well as a pool to access when lower market levels warrant a shift to equity. But the investor can potentially afford to be a bit more confident of his ability to handle market volatility at that stage, and progressively reduce the allocation to fixed income to enhance returns – while still maintaining the percentage of fixed income assets to a significant level. It may be prudent to start with 50:50 allocation initially, and over years and experience of making regular investments, and implementing the asset allocation and re-balancing strategy, progressively reduce the fixed income allocation – but perhaps, never dropping it below 25%. As market vagaries will still continue, and he will still need a store to take advantage of it – and in larger quantities to make an impact as his portfolio size increases.

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5 Steps to Simplifying Portfolio Strategy using Asset Allocation

A lot of individual investors are so interested in getting answers to questions like which stocks to buy, at what price and when to sell – that they do not realize that these are the least important questions to get answered when it comes to building long term wealth.

Perhaps the single most important decision that influences long term returns has got to do with allocation ratio of asset types. That is – how much of my income after expenses – i.e. savings – do I put in various types of assets across stocks, fixed income, real estate, gold and cash? This is broadly referred to as portfolio asset allocation in financial parlance – and is the single most decision that impacts long term returns.

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For simplifying portfolio strategy, all the opinions and advice can be essentially reduced to, in my view, a set of few simple steps:

1. Decide your asset allocation based on your life circumstances: For an individual who does not intend to do investments full time (i.e. has a job or business for his regular income), an allocation of up to 60% in equity, 10% in gold and the remaining 30% in cash and fixed income might be the optimal allocation. It may not give best returns, but is likely to be something that is practically followed over the long term.

2. Select your core and peripheral assets within the allocation: For most individual investors, index funds or select actively managed mutual funds are the best vehicles for equity participation.

3. Review once a year, and Rebalance when allocation ratios go out of whack: i.e. if equities have grown and now account for 70% of assets, shift 10% into others by selling; similarly if cash/fixed income or gold value has increased, shift proportionately into equity.

4. Set up a system for this: both contributions and rebalancing, so that you do not have to take decisions frequently.

5. Keep increasing absolute amounts or relative asset allocation, as your income levels increase or decrease, life circumstances change or ability to take risk alters.

This can be a framework for deducing a simple investment portfolio strategy for most individual investors. Once this is set up, the investor is likely to realize how unimportant the question of which stock to buy and when to sell really is.

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