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Long term asset allocation for Defensive Investors

This article was published in as a guest article on June 25, 2018. Here is the link to the freefincal article.

In his investment classic ‘The Intelligent Investor’, Benjamin Graham makes distinction between two type of investors; the “enterprising” and the “defensive”. Enterprising investor devotes time and effort required for the selection of stocks, bonds and mutual funds that can generate higher than average market return. Defensive investor on the other hand lacks time or knowledge required for enterprising investing. He therefore places his chief emphasis on avoidance of serious mistakes or losses, aims to be free from bother and is satisfied with average market return.

Enterprising investing is certainly more exciting, glamorous and rewarding compared to defensive investing. But it takes great deal of time, effort, skill and deeper understanding of investing to improve the result, easily achieved by the lay investor, by investing in index funds or actively managed mutual funds. A little extra knowledge of investing is not enough to beat average market return consistently over long period of time. Even professional investors and mutual fund managers find it difficult to do better than simple market averages or index funds and most don’t.

Retail investors with their full time jobs or superficial understanding of investing have little chance of doing successful enterprising investing. Therefore, no matter how much risk they are willing to take, they have to adopt the conservative approach of defensive investing. They are also better off leaving majority of investing decisions to professionals by investing in multi-cap category equity funds or index funds for equity part of their portfolio; and debt mutual funds that invest in high credit quality papers and simple fixed income instruments like PPF for fixed income part of their portfolio.

The only investment decision non-enterprising investors have to make is allocation of assets between equity and fixed income; the two most important asset classes available for them. This article discusses the nature of these two asset classes, the risks associated with them, and asset allocation non-enterprising retail investors can have between the two, for their long term investments.

The need for investing in both fixed income and equity
One of the most important factors in investing is inflation. Inflation reduces purchasing power of money, and therefore investments need to earn return equal to inflation just to maintain purchasing power.

Interest rates on short term fixed income instruments like bank fixed deposits, returns of liquid funds and short term debt funds investing in debt papers with 6 to 24 month duration, and interest rates on instruments like PPF roughly move in line with inflation. Interest rates/return on these instruments go up as inflation goes up and go down as inflation goes down (the relationship is not perfect). These fixed income instruments therefore do the job of protecting purchasing power of money to some extent.

(When inflation goes up, RBI increases interest rates to fight inflation; but interest rate hike may also have negative impact on the economic growth. Therefore, when inflation comes under control, interest rates are reduced to increase economic activity in the economy. This is a simplistic explanation. )

Return from liquid funds and short term debt funds temporarily go down when interest rates go up since NAV of the fund is lowered so that new investors in these funds earn higher interest rate prevailing in the market. This effect is cancelled out when investments are held for a period equal to modified duration of the fund. Modified duration can be thought of as number of years at which investor can be indifferent to an increase or decrease in interest rates. Returns from debt funds when held for a period more than modified duration, after interest rates have gone up, go up since new investments and maturity proceeds of old debt papers are invested at higher interest rates. The opposite effect occurs when interest rates go down.

Modified duration is also the multiplier that roughly links interest rate changes with changes in NAV of the fund. If modified duration of a debt fund is 1 year, NAV of this fund will reduce by 1% if there is instantaneous 1% increase in interest rates. Likewise, NAV will go up by 1% if interest rates go down by 1%. Since modified duration of liquid funds and short term debt funds is low, they are less impacted by the interest rate changes. These funds also quickly recover from the impact of interest rate movement and start giving return in line with prevailing interest rates in the market. 

Long duration bonds and long term debt funds on the other hand can beat inflation handsomely when inflation goes down but there is always danger of inflation shooting up instead of going down. If inflation shoots up, investors can get stuck with bonds that pay lower interest rate compared to inflation especially when interest rates on bank fixed deposits and returns from liquid funds and short term debt funds have gone up.

A long term debt fund, investing in papers with average maturity of over 10 years can have modified duration of over 7 years. This means that if interest rates go up by 1%, this fund will lose 7% of its value and it will take 7 years for the fund to recover and reach expected return before interest rates went up. Such funds can also deliver 7% return in a single day if interest rates go down by 1%. But since non-enterprising investors can not predict inflation and interest rate movements in the future, they are better off sticking to short duration fixed income instruments and instruments like PPF where interest rates are reset every quarter.

Return on fixed income part of portfolio can be increased by investing in higher interest bearing instruments like co-operative bank fixed deposits or debt mutual funds that invest in lower credit quality debt papers. But principal is also at higher risk in such instruments. A defensive investor who wants to be free from bother should stick to fixed income instruments where principal is at minimum risk.

The trouble in keeping all money in fixed income instruments is that post tax return from these instruments can rarely be higher than inflation, and therefore investor’s savings and investments do not grow in purchasing power. It is also difficult for majority of retail investors to finance all their important financial goals by putting all their savings in products which generate no real return (return post inflation). Therefore, investors must also invest in instruments/asset classes that can generate return higher than inflation.

Equity is one asset class that has given higher return than inflation over long period of time. The real return (return post inflation) from equity has been typically at a level of 3% to 6% in markets for which long term market history is available. In more successful economies like US, the real return on equity is higher than 6%. (Source: Credit Suisse Global Investment Returns Yearbook 2018).

It is generally accepted that equity provides hedge against inflation, but it is not entirely true. The correlation between equity returns with rate of inflation has been small. In fact, contrary to the popular opinion held by majority of equity investors and advisers, authors of the book Triumph of the optimist: 101 years of Global Investment Returns, note  “inflation appears to have had negative impact both on stocks and bond markets.”

Historical evidence tend to suggest that equity does well when inflation is moderate but when inflation heats up to high levels, even equity fair badly. This is because, when inflation is mild, companies can pass the increased cost to consumers, but high inflation force consumers to cut their spending resulting in depressing activity throughout the economy.

Equity also does poorly when inflation is negative (deflation). This is because, when the prices of most goods and services go down, companies struggle to increase their profits. This is what happened in Japan after 1990.

Equity is considered as inflation hedge simply because it has generated real return over long period of time.

Long run equity returns can also mislead investors into underestimating the risk involved in equity investing. Returns from equity could be extreme in the short run. Here are few cases of extreme short term equity returns to give an idea about how bad things can go wrong when they do go wrong for equity investors. US stocks lost 89 percent of their value between 1929 and 1932 from peak to trough. In 1973-74 bear market, US stocks fell 52% in real terms. On October 19, 1987, US investors lost 23 percent in a single day. Between March 2000 and October 2002, US stocks lost 50 percent of their value. From October 2007 to March 2009, value of US equity went down by 60 percent. 

Many investors and advisers show long run return history of Indian and US equity markets and argue that equity becomes risk free and generates real return if held for more than 10 years. The flaw with this argument is that it takes into consideration only two equity markets, the data for which is easily available. Both these market histories have limitations of their own. India has too short equity market history to draw any meaningful conclusion about the long term equity returns. US on the other hand emerged as the most successful economy in the world. Drawing inferences based on the market history of world’s most successful economy can show long term return from equities in an unduly favorable light and may give misleading impression about the future expected equity return in India. It is dangerous to treat US data as universally applicable.  

For more balanced view, we also need to look at equity returns in other markets and see if the assumption that equity is guaranteed to generate real return for all time frames greater than 10 year holds true or not. The longest period of cumulative negative real return for the US was 16 years from 1905 to 1920. This period was 22 years from 1900 to 1921 for UK, 51 years from 1900 to 1950 for Japan, 55 years from 1900 to 1954 for Germany and 54 years from 1929 to 1982 for France. (Source: Credit Suisse Global Investment Returns Yearbook 2018)

Japan’s leading stock index Nikkei 225 was at 38,915 at the end of 1989, close to 3 decades later, it still languishes below 23,000. Stock markets of other countries like Argentina, Italy, Russia and Switzerland have gone through similar long periods of disappointing returns. 

This should be a reminder that equity returns could be poor over multiple decades and fixed income instruments can give higher return than equity even for a few decades.

The intention here is not to scare investors out of equity but to make them aware that there are no guarantees in equity even when investments are held for long term. There is always element of unpredictability associated with equity investing though it is highly likely to beat other asset classes over long term.

Fixed income investing is not risk free either since inflation eats up all the gains and there is risk of not accumulating enough for important financial goals in a 100% fixed income portfolio.

Investors can never completely eliminate risk from investing. Therefore, they have little choice but to allocate their long term assets both in equity and fixed income.

What should then be equity:fixed income allocation for non-enterprising investors?
In ‘The Intelligent Investor’, Benjamin Graham recommends that the equity allocation should never be less than 25% and higher than 75%. Allocation can move between these two limits depending on the market condition. If equity is available at bargain price level, equity allocation can move towards 75%; conversely equity allocation should be lowered when market valuations are expensive.

While enterprising investors can think of dynamically managing equity:fixed income allocation, most retail investors can not do it. Equity also has habit of making fool of even mature investors. It further goes up when valuations are already stretched and goes further down when equity valuations appear to have bottomed out.

Benjamin Graham therefore recommends 50-50 formula for non-enterprising investors. He recommends investors to hold 50% of their assets in stocks, and 50% in fixed income. When changes in the market level raises equity component to say 55%, the balance is restored by selling 1/11th of the stock portfolio and transferring it to fixed income. Conversely if fall in the equity market takes equity allocation to say 45%, 1/11th of fixed income assets are used to purchase additional equity.

This allocation makes perfect sense for a non-enterprising investor who can not dynamically manage asset allocation. If there are lucky outcomes and equity generates real return, half of his portfolio benefits from it. On the other hand, if there are unlucky outcomes and equity underperforms fixed income, which can also happen, he is still better off compared to other investors who are heavily invested in equity.

There is more to 50-50 equity-fixed income allocation than inability to manage asset allocation dynamically. Equity is an unpredictable asset class in the short run, but it has proven to be a reliable asset class over the long term. Therefore, to invest in equity with success, one must be a long term investor. A 50-50 equity-debt mix makes it easier for an investor to stick to the long term investment plan compared to more aggressive equity allocation. 50-50 allocation soothes up shocks equity throws from time to time. Even when market cracks up by 50%, a 50-50 portfolio will not go down more than 25%. 25% is still painful but is nowhere close to the pain experienced by investors with 50% portfolio drawdown.  It is far easier to stay the course with 50-50 allocation compared to aggressive equity allocation.

50-50 allocation sounds too conservative to many advisers and DIY (do it yourself) investors. These investors and advisers typically have blind faith in the long term performance of equity and they usually recommend higher equity allocation to all investors when investment horizon is long.  Even if we assume that equity is guaranteed to outperform fixed income over long term, there is still one flaw with this advice.

This advice doesn’t take into consideration the emotional muscle required to handle high equity allocation. Both advisers and DIY investors live in a world where equity is an inseparable part of their daily life. This is not always the case with majority of retail investors. A high equity allocation accompanied by bad sequence of return can make an untrained equity investor so risk averse, that his average equity allocation over lifetime could become lower compared to a case where he is recommended a more conservative allocation. Even 50% equity allocation is too high for an inexperienced investor; and allocation should be gradually increased to 50%, to reduce behavioral risk which is highest when investor is inexperienced.

Many DIY investors think that they have high risk tolerance and can withstand deep drawdowns of equity markets. In reality, their perceived high risk tolerance is product of favorable stock returns of the recent past. A benign market correction is enough to disrupt long term investment strategy of most of them. It takes crazy faith in equity to stay rational in a long drawn bear market. Faith of most DIY investors in equity is too fragile to withstand 2008 like drawdown. DIY investors can do fine by not overestimating their own risk tolerance and adopting the more conservation 50-50 equity-fixed income allocation for their long term investment portfolios.

P.S.: This article specifically talks about the long term asset allocation for non-enterprising investors. Investors should reduce equity allocation as the goal approaches, to reduce bad sequence of return risk.

A good part of this article is the result of my long discussions with Avinash Luthria, whose SEBI RIA application is under process. We have been talking for an hour, every weekday, for over seven months now. Avinash shared Credit Suisse Global Investment Returns Yearbook 2018 with me. Phrases like ‘crazy faith in equity’, ‘emotional muscle’ used in the article are also the phrases Avinash used sometime during our discussions.

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