The other day I saw this funny clip from a Jerry Seinfeld comedy show that made me think of asset allocation in investing. Here's what he says, "Sky diving was definitely the scariest thing that I've ever done. Let me ask this question from the people who do sky-diving. What is the point of the helmet in sky-diving?" So if you dive from the plane and the parachute does not open, how exactly does the helmet help?
It's funny, and as far as I can think of in my own line of work, it definitely has a parallel. There is this idea of asset allocation. It starts from the concept that no one should have only equity or only fixed income in their investment portfolios. To anyone who is reading this, the basic concept would surely be familiar. Briefly, equity provides high returns but can be volatile in the short-term so must only be considered for long-term investments. Fixed income has lower returns but higher stability so must be there for short-term needs as well as providing stability during exceptionally volatile times.
So far, so good. Some investors are fundamentalists on one side or the other but most would not argue with the concept itself and how it must be practised by every saver. The problem arises with the question of how much. That's where Jerry Seinfeld's sky-diving helmet comes in. I see equity purists who make a concession to the idea of asset allocation and add maybe five percent fixed income to their investments. That five percent is the sky-diver's helmet. If your parachute does not open (there's a crash in equities), the five percent debt exposure will be about as useful as the helmet.
Look at any big crash of 20 to 40 percent in equity NAVs, say 30 percent. If you start with 100 percent equity and an investment value of say Rs 10 lakh, you lose Rs 3 lakh. If five percent of your holdings were fixed income, then you lose Rs 2.85 lakh. There's your helmet right there. So how much of your portfolio should be fixed income? Now, one can get very complicated with this but like in every other investment matter, I would vouch for simplicity. Depending on your stage of life and your general attitude towards risk and returns, choose between 1/3rd, half or 2/3rd.
In the above example, a 1/3rd exposure to fixed income would mean that instead of Rs 3 lakh, you lose Rs 2 lakh. Half and 1/3rd would mean losses of Rs 1.5 lakh or Rs 1 lakh. Those are meaningful improvements. In the midst of a crash, it would be a significant financial and psychological comfort to you.
Of course, maintaining a particular ratio between equity and fixed income would mean a little bit of work in terms of asset rebalancing but that's worth it. We'll discuss that in another column in the near future. However, with a little help from hybrid funds, it's not difficult to do.
Interestingly, this helmet also exists at the other end of the asset allocation spectrum. There are people who are entirely invested in fixed income but pay a little bit of lip service to equity investing because of its ability to generate good returns. They have five or ten percent of equity mutual funds in what is otherwise a fixed income asset base. Again, it's the same problem. Even if the the equity investment does phenomenally well, it hardly moves the needle in terms of the total investment portfolio they have. This is especially true when one takes the typical families' entire asset base because mandatory retirement savings like PF tend to be entirely or very heavily biased towards fixed income.
Of course, because equity is fundamentally different from fixed-income securities, the same percentages that I recommend above for fixed income are not exactly appropriate. Again, this is a large topic by itself and we'll discuss it another time soon.