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The case for a fixed choice
Even the most die-hard equity fan must ensure that at least some of their investments are in a fixed income option
By Dhirendra Kumar | Jun 24, 2019
As regular readers must have noticed, I have often lamented the excessive reliance on fixed income that Indian savers are prone to. India has traditionally been a 'fixed income country'. Generations of savers turn automatically to savings instruments like PPF, bank deposits, post office deposits, etc for all their savings needs. This is something that I've often written about and pointed out that long-term savings and investments must be invested in equity or equity-backed mutual funds.
Interestingly, it increasingly looks like a certain proportion of younger savers have taken to the equity mantra a little too much. Savers who get start investing in equity mutual funds and have a good experience tend to go almost 100 percent into it. This is a mistake, and the reasons are the twin concepts of Asset Allocation and Asset Rebalancing.
These sound complex but are easy to understand in just three steps. One: Broadly, there are two types of financial investments, equity (shares) and fixed income (deposits, bonds etc). Two: Equity has higher potential gains and more risk, while fixed income has lower but steady gains. Depending on your needs, you should be investing in the two in a particular proportion. This proportion, and the process of arriving upon it, is called asset allocation. Three: As time goes by, equity and fixed income gain at different rates, thus disturbing the desired asset allocation. Shifting money between the two to restore that allocation is called asset rebalancing. That's it.
The question is why does it work? The basis for asset allocation is that the two types of financial assets - equity and debt - are fundamentally different. Not only are they different, they are complementary. In terms of the conflicting need of investments to give high returns and high safety, each plays a role that fills in the other's deficiencies. Let's see how that happens.
There are just three ways that an investment can make money. One, by lending money to someone who pays interest on it, be it a business or a government. Two, by becoming a part owner of a business, as in having a share in it. And three, by buying something that becomes more valuable, like gold or real estate or indeed any possession.
Equity grows faster than debt (which means all kinds of deposits), but is much more volatile. There are times when it will rise much faster than debt, and there are times when it will grow slower, and will fall. It turns out that the best way to protect as well as take advantage of the fact is to decide upon a percentage balance between equity and debt and stick to it by periodically shifting money away from the one which becomes high and to the one that becomes low. When equity is growing faster than fixed income - which is what you would expect most of the time - you would periodically sell some equity investments and invest the money in fixed income so that the balance would be restored. When equity starts lagging, you periodically sell some of your fixed income and move it into equity. Inevitably, things revert to a mean, and that means that when equity starts lagging, you have taken out some of your profits into a safe asset.
There is practically no case for any individual having no fixed income investments at all. The only question is what kind. For individuals who like to keep it simple, the entire thing can be done within hybrid mutual funds. The asset balancing and allocation all happens transparently and effortlessly within the fund. Even the traditional favourite, Public Provident Fund (PPF), is not a bad choice because it does provide tax savings as well as tax free returns, although the very long lock-in period is problematic.
No matter how completely you have bought into the equity story and what route you take, some fixed income investments are a must for everyone.