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How conservative investors risk falling short of their goals

A reader query prompted this post on the risks of not investing in volatile assets for long term goals.

How conservative investors risk falling short of their goals

Posted on 02 Mar 2022
Author: Sayan Sircar
11 mins read
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A reader query prompted this post on the risks of not investing in volatile assets for long term goals.

How conservative investors risk falling short of their goals

📚 Topics covered:

Being new to mutual funds, not able to initiate any investment related formalities thinking about the adverse effects. How to motivate ourselves and move forward? - Reader

Risk vs volatility

I have come across many people who delay investing due to innate fear or misunderstanding of how investing works. The noise coming from financial media, specifically the negative ones, adds to their anxiety. There are also misconceptions at play here, with “stock markets are gambling” being one of them. The result delays in starting investing that can go well into the forties. The delay can be traced back to a misunderstanding related to the concept of volatility and risk.

Volatility is the fluctuation of the price of something. In the context of investing, volatility is the prices of stocks and bonds going up and down for various reasons. However, it is easy to conflate volatility with risk, but they are not the same. Risk is best illustrated with some examples. Risk is:

  • running out of money during retirement since you avoided volatile assets throughout your life
  • unable to send your child to the preferred college due to faulty planning
  • paying unnecessary taxes due to dividends and interest income in the accumulation (pre-retirement) phase that reduces the compounding effect

There is no guarantee that investing in volatile assets will eliminate these risks. You can minimize risks by choosing and executing goal-based investing as a plan. However, unless the portfolio value is substantial compared to the goals (say ten crores vs ten lakhs), avoiding volatility will surely lead to the risks as described above.

What happens if I invest and the market falls

A common fear of late investors is that I invest 50 lakhs today, and the market will fall 20-30% soon. The question to ask at this point is: so what? We can say so what because of two reasons: 1. If the market falls, it will recover. 2. Only the money you will not use for the next ten years or more will be invested in equity.

It is indeed painful to see your investments fall in value. But that is normal in an asset class like equity that fluctuates a lot in the short term but generally goes up in the long term.

When you create a portfolio, you need to invest monthly as per income, called Systematic Investment Plan (SIP), and invest the money you have at hand for the same goal, the lump sum. The lump-sum may be a substantial amount for late investors, say 50L or a crore or even more. It is normal to fear the fate of this investment since you have never invested in risky assets before.

Lump sum investment

The longer you stay invested with a lump sum, the more likely you will not lose money, as shown below. We will use Nifty 50 price index data from 1993 to calculate this probability across multiple holding periods. We see that only beyond ten years or more, the likelihood of losing money drops to mostly zero.

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Nifty holding period probability for lumpsum

If we repeat this analysis with some chosen active funds with data from 2006, we see the same result.

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Active MF holding period probability for lumpsum

To average the initial fluctuations, investors should spread this lump sum investment over a few months up to one year. This plan will slowly familiarise them with market volatility.

SIP investment

We use actual Nifty 50 price index returns to show running a 25-year SIP. The result shows a significant variation in the final portfolio amount depending on the SIP and the intermediate yearly returns.

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Nifty 25 year SIP

However, we also see that the overall return has been positive as per past data.

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Asset allocation to the rescue

Without asset allocation: this is the dangerous scenario

Without asset allocation

With asset allocation

With asset allocation

Asset allocation is the not-so-secret secret sauce of creating a portfolio that ensures that irrespective of what the stock market does, you have money at the time you need to spend it. Having the proper asset allocation ensures that

Lifecycle of your goal with proper asset allocation

Portfolio vs goal paths

Once you start investing, the process looks like the image above. The blue line is the goal that increases at a smooth rate over the goal horizon of 20 years. This line is smooth since this is theoretical, assuming average returns from the assets in the portfolio, which would typically be equity and debt. The SIP amount is expected to increase linearly by a fixed percentage (like 5% or 10%) to accommodate rising income.

In real life, however, there will be two changes:

  • market returns are unpredictable
  • your income may or may not the sufficient to plug the gap in case you fall behind due to insufficient market return

The first point (unpredictable returns) is countered using the concept of rebalancing, which manages portfolio risk by following a glide path. The glide path progressively reduces the exposure to risky asset classes as the goal comes closer, thereby locking in the returns at every point.

The orange line is the portfolio that fluctuates due to market risk. You are essentially trying to keep the orange line above the blue one at all times by adjusting the SIP amount and rebalancing to manage risk.

The concept of the life-cycle of a goal is described in more detail here: What is the lifecycle of a goal?

What if I cannot get over my fear

The danger of inflation

Inflation is an essential input to goal-planning in an economy that rises overall. We can use the rule of 72 as a convenient mental shortcut to understanding the impact of inflation.

Rule of 72

The rule says: Rate of doubling * Time in years = 72

Rule of 72 lets us quickly calculate the impact of inflation over time. Using the rule, we can see that

  • the purchasing power of money halves every ten years at 7% inflation. For example, one crore worth today will be worth 50 lakhs in 10 years and 25 lakhs in 20 years
  • a lump-sum payout, say from an insurance plan, is worth around four times less in today’s money if received in 20 years
  • if you need one lakh/month in living costs in the first year of retirement, that will be two lakhs/month in ten years and four lakhs/month in twenty years
  • if a UG college degree costs 20 lakhs today, it will be 4x that, i.e. 80 lakhs in 14 years at 10% inflation for a 4-year-old today

The above examples show the danger of linear thinking when money is involved. For example, any goal planning that ignores the effect of inflation will lead to inevitable failures when it is time to spend the money. Similarly, investing in insurance plans that give a fixed return over life will lead to getting smaller and smaller amounts in real terms that will be useless in the later years of retirement. The actual calculation is an application of the compounding formula like this:

Cost after N years = Cost today * (1+Inflation) ^ Time

To beat inflation, one of the best options is equities. Historically equities have outperformed inflation in India and abroad, and the trend is expected to continue. This article discusses choosing equity investments in detail.

Apart from equity, there are many debt instruments for retirement corpus creation. This list includes debt mutual funds, NPS, provident funds and others, covered in more detail here.

We have performed a detailed analysis of debt fund category returns vs inflation in this post: Can debt funds beat inflation?

Only low risk investing

The wish of avoiding equity assets in retirement is common among investors

  • who have never invested in equity throughout their life due to various reasons
  • who have a belief that if their corpus is large enough, an FD/pension is all they need since it gives guaranteed income

It is not compulsory to invest in equity for long term goals with the caveat that the corpus you generate will be much smaller in debt funds and FD. We have dealt with this case in detail in this post: Can you retire by keeping money only in FD or pension?.

Paying unnecessary taxes

Interest income from savings accounts, FD and bonds as well as dividends from stocks are taxable at your highest tax rate. If you have income from salary or profession, you are wasting a part of this capital as taxes since that does not get a chance to grow. A debt mutual fund, like from here, is taxed at a lower rate post indexation only when you sell the units. You can learn about tax calculation here: How is tax calculated on selling shares/MFs and how do to do tax harvesting?.

The only way you can justify keeping money in FD if you are an NRI in a low tax jurisdiction and do not have to pay taxes on FD income in India.

Read about and implement Goal-based investing

The right way to invest is to follow Goal-based investing. This investment method is described in three parts:

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