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The Stepping Stone

The first step towards ensuring you meet your target is deciding the asset class you need to invest in…

Last week, I wrote about how investors who are targeting a particular financial goal should allow for inflation when they make their future projections. Inflation and returns are two variables both of which have a compounding effect. Even small errors in the estimating either can leave you far from the target. However, getting your estimates right is just the beginning of the job that you need to do. The most important variable that decides whether you will meet your target or not is the nature of the actual investments. The first step in getting this right is to decide what kind of asset class you need to invest in. By asset class, I mean debt or equity. This is the primary decision that you will have to make.

Conventionally, the difference between debt and equity is that of their risk level. When I say debt, that encompasses bank deposits, government-backed deposits, other deposits as well as mutual funds that invest in debt paper. Equity means stocks as well as equity mutual funds. Everyone knows that debt is less risky than equity and that’s true. However, for the purpose of planning a targeted investment, it’s more useful to think of debt and equity in a different.

The important difference between the two is that the risk and return curve of the two varies in a very different way over different time-scales. Debt returns are predictable and there are many government-guaranteed deposits available to the Indian investor. However, debt returns are low, barely matching or only slightly exceeding the rate of inflation. Equity returns have the potential of being much higher but can be volatile. However, the volatility of equity is a relatively short-term phenomenon. For periods exceeding three to five years, equity investments are extremely likely to give strongly positive returns. This is especially true if you stick to a broad selection of the relatively larger-cap companies and if you invest gradually, as in an SIP.

Speaking in risk terms, this means that instead of saying that equity has higher risk, we should actually be saying that equity’s risk drops over time and at a long-enough time-scale, the returns-to-risk ratio becomes far more attractive than debt. And there’s the point about how all this fits into your targeted investment goals. The formula is simple—debt for the short-term and equity for the long-term. Of course, this formula is well known. However, there’s brings us to a most important factor, and one that is rarely appreciated. The ‘short’ and the ‘long’ that we are talking about here refer not to the total period over which you are investing for a target. Instead, it refers to the time remaining till the point when the money will be needed. You may have worked for a decade towards buying a house and thus treated it as a long-term investment. However, when you reach a stage when the realisation of the target is about two years away, then the risk profile should be that of a two-year investment. And that means a safe and sound fixed-income option. Otherwise, a bear phase in the stock market could easily wipe out a big chunk of the returns that your equity investments have accumulated over the previous eight years and leave you much further from your goals.

This necessity of treating a targeted investment according to the time remaining rather than the total time from the beginning means a major modification in the way you exit an investment. To facilitate a ‘soft-landing’, an investor should pull out money gradually from equity and redeploy it into a fixed income avenue as d-day for that investment comes closer, as a process that is the reverse of the SIP. This underscores the role of fixed-income investments in every portfolio. It’s all very well to say that you can bear the risk of equity, but as we’ve seen above, the debt’s role as a protector of returns already generated from equity is indispensable.