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Goal-based investing: should you use a unified portfolio?


11 Oct 2021 - Contact Sayan Sircar
10 mins read

This post shows how to simplify portfolio construction and management via a unified portfolio along with its associated risks.

Goal-based investing: should you use a unified portfolio?

Table of Contents

What is a unified portfolio?

A unified portfolio has a single asset allocation (equity, debt and other asset classes) for all goals irrespective of goal horizon and priority. As a result, the risk profile of the investor will be considered uniform for all goals.

Compared to other alternatives, a unified portfolio has two straightforward benefits:

  • easier construction and maintenance
  • smaller starting SIP amount

However, this method of portfolio construction has a different and higher risk exposure than other asset allocation methods. The objective of asset allocation and rebalancing is to ensure that the goal is reached. Whenever money needs to be spent, it should be available in the portfolio. The withdrawal does not adversely affect the portfolio due to the market movement of the asset values.

Higher risk exposure is the major criticism of having a unified portfolio. For example, assume a 5% withdrawal from a portfolio during a bear market event like March 2020. There will be a disproportionate withdrawal coming from the equity section of the portfolio, which has already fallen a lot. This is an example of sequence-of-returns risk that was discussed in more detail in this post.

A unified portfolio requires a lower starting investment amount

The base case, as described here for a family, is this:

Calculation of SIP amount for multiple goals

If we convert the asset allocation to a 60:40 equity to debt allocation for all goals, keeping everything else constant, we get:

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Calculation of SIP amount for multiple goals using unified portfolio

We see a substantial reduction in the SIP amount needed to start investing, enticing investors. However, the lower initial investment for the same goals implies a higher risk that is being taken. To demonstrate the effect of this risk and highlight the appropriate risk management practices, we perform the following analysis on risk management.


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Testing methodology for risk management

This article will consider the following four portfolio construction methods and show how they fare for a retirement goal:

  • Case 1: Simple unified portfolio with fixed asset allocation
  • Case 2: Split-goals/Fixed asset allocation (this is used in the second table above)
  • Case 3: Split-goals/Reducing Asset allocation (this is not a unified portfolio)
  • Case 4: Split-goals/Fixed asset allocation, cash within five years (mix of cases 2 and 3)

In each case, we will rebalance yearly. The investor will be investing ₹ 3.5 lakhs/year for 30 years with a 10% increase in investments every year. After 30 years, new cash investments will stop, and they will draw down the portfolio for a retirement period of 40 years. The lifestyle in retirement will be the same as five lakhs/year in today’s money and will be adjusted by inflation at 7% throughout 70 years.

Due to the absence of data for Indian stock markets for long durations, we have performed a Monte Carlo simulation (using NORMINV(prob, mu, sigma) formula in Excel). The purpose of this exercise is a relative comparison of the four methods for which this methodology is sufficient. In addition, we have assumed both market risk for equity component and credit/interest rate risk for the debt component of the portfolio. Therefore, an appropriate choice of assets is a total stock market fund for the equity section and a total bond market fund for the debt section. Finally, we have assumed a 60:40 equity to debt split for the unified portfolio. For simplicity, we have assumed that the market returns are post-tax related to rebalancing and withdrawal.

In each of the cases, the investment amounts are the same. This allows for the fact that just because the goal is not on track, there may not be enough funds available to allocate all the time.

Case 1: Simple unified portfolio with fixed asset allocation

In this case, we invest money every month into a fixed asset allocation of 60:40. Then, every year we rebalance to bring the asset allocation within the prescribed limit. In the withdrawal phase, we withdraw what we need for running the household for that year when rebalancing.

Case 2: Split-goals/Fixed asset allocation

This case is different from the case above since we will first split the retirement goal into 40 goals, one for each year of retirement. This is the same method described in this post on multiple-payment goals.

We then start investing separately for each goal in a 60:40 ratio and rebalance yearly. Finally, to simplify the investment, we combine the SIP amounts in Excel to have just one pair of SIPs running at any time - one for equity and one for debt.

Case 3: Split-goals/Reducing Asset allocation

We modify case 2 above by reducing the equity allocation over time for each goal out of 40. For each goal, we will follow the following glide-path from this post:

  • if the goal is more than 15y away: 60:40 allocation
  • if the goal is less than 5y away: 0:100 allocation, i.e. entirely in debt
  • if the goal is between 5 and 15y, the equity component will be linearly changed from 0 to 60% for the intervening period

Since there are 40 goals, each will be at a different asset allocation at all time points. To simplify management, we will combine the SIP/withdrawal amounts using Excel. This is the method followed in the standard risk-management and portfolio construction method recommended here.

Case 4: Split-goals/Fixed asset allocation, cash within five years

Case 4 is a particular example of case 3 where the asset allocation per goal is:

  • if the goal is more than 5y away: 60:40 allocation, i.e. primarily in equity beyond five years
  • if the goal is less than 5y away: 0:100 allocation, i.e. entirely in debt before five years

Compiled results

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Unified portfolio: 4 cases

We define the following parameters to compare the results:

  • Success: Proportion of cases that supported a 40-year retirement without running out of money in the middle
  • Median: Portfolio ending value after 40 years. We use median instead of average due to extreme values in case 1
  • Worst 5%: this is the average of the worst 5% portfolio ending values. Lower this number, the riskier is the approach

The ideal risk-management approach combines a high success rate with a not very low value of the worst 5% metric with a non-negative median of ending portfolio value. A non-negative median implies at least half the ending values are more than 0, i.e. success rate is more than 50%.

We see an extensive range of returns in the first case, while the deviation is relatively modest in the other three, with the portfolio value converging close to zero at the end. This result shows that you should avoid the first option.

Cases Success Median Worst 5%
Case 1: Simple 73% 9,942 -14,177
Case 2: Rebalanced / Flat AA 68% 231 -379
Case 3: Rebalanced / Reducing AA 47% -21 -427
Case 4: Rebalanced / Flat AA + Cash 53% 37 -393

Instead of recommending one method over another, we will encourage you, the reader, to draw your conclusions from the data presented. As long as you realise the inherent scope of the disaster in the simple unified portfolio presented in case 1, as evidenced in the worst 5% figure, that will be a good takeaway.

Special case: low-risk debt portfolio

Unlike the cases above, we will see what happens in all four instances if the debt portfolio is chosen with minimal credit and interest rate risk, in line with the recommendation in this post on choosing debt mutual funds. This way restricts market risk to only the equity component of the portfolio.

With 60:40 allocation we get:

Cases Success Median Worst 5%
Case 1: Simple 50% 160 -15,734
Case 2: Rebalanced / Flat AA 43% -55 -435
Case 3: Rebalanced / Reducing AA 11% -243 -474
Case 4: Rebalanced / Flat AA + Cash 29% -186 -457

Since the equity component only has risk, we up the allocation to 70:30 to get:

Cases Success Median Worst 5%
Case 1: Simple 67% 9,423 -14,967
Case 2: Rebalanced / Flat AA 74% 226 -405
Case 3: Rebalanced / Reducing AA 35% -102 -458
Case 4: Rebalanced / Flat AA + Cash 50% -8 -436

The above two tables underscore the importance of building a diversified equity portfolio which has exposure to different countries and factors (size, value, volatility and yield) so that equity exposure of the whole portfolio can be increased without increasing overall risk.

We need to be mindful that as the economy matures, interest rates will fall, leading to lower returns from the debt component of the portfolio. This risk is inherent in all strategies. If we assume that the risk premium, relative to inflation, remains constant for equity and debt, then the above calculations adjust for this risk.

Conclusion

A unified portfolio is appealing given its simplicity, ease of maintenance and small investment amount. However, it is essential to use a calculator that manages the risks involved in a way that maximises the chances of reaching your financial goals. Given the availability of tools like Excel and even more straightforward calculators like this, it is vital to use them to ensure that you are not taking any unnecessary risk.

Please contact us using the links below to get a copy of the Excel sheet used to generate the numbers in the post (2021-10-11-unifiedPortfolio.xlsx).

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