Dangers of avoiding Stock Market in long term portfolio

Investors are of two kinds.

Some are risk averse and some are risk takers.This article is about and for the Risk Averse Investors.

Portfolio for Risk Averse Investors

Risk Averse Investors tend to believe the price volatility of the stock market as risk. Hence, they tried to avoid the stock market altogether. Is this really wise ?

While it may seem prudent not to invest in the stock market, and lose sleep due to price fluctuations, it is not really a wise thing to do.

Instruments of Savings and Investments always carry three risks.

  1. Capital erosion – not getting back the original investment
  2. Inflation – not getting the purchasing power
  3. Taxes – not able to keep all the gains ourselves

Usually the risk averse investors are fully aware of the risk of capital erosion and are but blind sided by other two risks. They don’t think too much about the Inflation and Taxes, which are equally dangerous.

Risk Averse investors put all their money in fixed income securities like bank fixed deposits, post office schemes, company deposits etc., All over the world, these fixed income securities are the instruments that are taxed heavily and also subjected to inflation risks. In the end, they lose purchasing power. So, the risk averse investors end up saving money from one shark and feeding it to the other two sharks.

What is Really a Risk in Investment ?

For financial goals with short term time horizon, the risk lies in preserving the capital. This is the money that needs to be set aside for an expense that is coming up in near short term. It could be a down payment for your dream home, or your vacation abroad, or money required for the college admission of your kid.

But for the financial goal that is years away – say 5 to 10 years – the real risk is meeting the ever increasing costs. For example, your retirement or your daughter’s marriage. While it is easy to estimate what is required in the next 6 months for your apartment payment, it is not easy to guess how much is required down the road in 20 years for monthly expenses.

There are lot of uncertainties. It is difficult to make an accurate estimation of how much we need. But the enemy of long term portfolio is known and it is called inflation. It is very important to know the enemy and conquer him, to achieve our portfolio goals. We must beat inflation and get a positive real return from our portfolio. Only then can we meet our planned financial goal.

While we don’t advocate stock investing for short term portfolio, for long term investing, stocks should be part of our portfolio. It does not matter whether you are risk averse investor or risk taking investor.

I studied Indian stock market return data for the last 22 years, with 5400 data points. I have used rolling returns for all my computations. There are 3 periods I have used for study.

  1. Three Year Period – total of 4790 data points. [It means there are 4790 three years period within the time frame I have taken]
  2. Five Year Period – total of 4570 data points
  3. Ten Year Period -total of 3385 data points

With a few graphs, I am going to share the summarized data and highlight my observations.

Qualification Criteria for long term investors who are risk averse:

  • Investment period = 5-10 years
  • Capital loss acceptable = None (0%)
  • Target return = above inflation return

For Risk Averse investors, their greatest fear is losing Capital. Capital Preservation is far more important than anything else. These investors are ready to work as many years possible and ready to take a  late retirement if they must. So, let us address that first.

Chart 1:

chart_1

For a 5 year period of investing, anything over 60% in stocks, there is a small chance of losing capital. For a 3 year period, the risk starts with >40% stocks. With increase in stocks ratio, ( when you travel on X axis from right to left, you are increasing stocks in the portfolio ), the risk of capital loss goes up steeply. It is a scary ride for 3 years portfolio compared to moderate risk seen in 5 years portfolio. For 10 year portfolio the risk is almost negligible at 100% stocks, but below 90% stock level, there is absolutely no problem of capital loss.

Since our target is long term investors who are risk averse, I suggest you ignore the 3 year data in this graph. And since we said no capital loss is acceptable, stock level should be 90% or lower. If it is around 5 years,the acceptable stock level is 60% or lower.

Let us next focus on proper allocation to beat the inflation. Because in long term it is important to beat inflation and get positive real return for the portfolio.

Chart 2:

chart_2

This chart shows the probability of beating inflation ( 7% inflation is assumed). Y axis is the probability figure and X axis shows the stock allocation in the portfolio.

As common sense would dictate, you expect

a) higher probability of beating inflation with higher stock allocation in the portfolio.

b) also the longer the holding period, the higher the probability will be to beat inflation.

Hence the chart is expected to show chart line going from up to down when we move from left to right (probability goes down as we reduce stock allocation ) for all periods and also we expect the 10 year line to be on top of the 5 years line and 5 year line over the 3 years line. ( Higher probability for longer period ).

Surprise ! We see some interesting curves here. Let us examine !

2D area – shows the probability of beating the inflation goes up when the portfolio is added with some bonds, regardless of the holding period. (against common sense !) This is the secret behind asset allocation. An intelligent financial planner always recommends a mixture of stocks and bonds in any portfolio. It is because you are reducing the portfolio risk by mixing various assets; you are eliminating single asset class risk. But as common sense would dictate the green curve is at the top, confirming the longer the holding period, the higher is the probability of beating inflation.

2A and 2B area are the efficient frontiers. Any lowering of stocks beyond this point, also reduces the probability of getting inflation adjusted return. This should be the point of interest for long term but risk averse investors. This is between 40% to 20% stock portfolio. Any reduction beyond 20% stocks in long term portfolio, increases the risk of losing against inflation. In other words, you lose the purchasing power beyond this point. And you become poorer slowly. While you may be seeing the nominal value of balance going up slowly, you will not be able to buy things that you dreamed of long time back.

2C is the real Warning for the investor. If you don’t hold any stocks in long term portfolio, you lose out big !

The graph clearly shows if you are risk averse investor, a minimum of 15%-20% stock is required in your portfolio. Anything lesser you are making an unintelligent decision.

With this clarity, let us see what would be the average return of this portfolio.

Chart 3:

chart_3

3A area shows with higher stock allocation and longer holding period, your average returns are higher. Common sense ! But where it gets interesting is area 3B.

A portfolio with 0% equity gets lower return in a 10 year periods compared to 3 years or 5 years period. Why ? Also after 3C, one can notice the the deviation is very significant.

As we go right on the graph, the bonds/fixed income allocation of the portfolio increases. Due to interest rate risk and duration risk of the fixed income part of the portfolio, the portfolio return is affected. Another lesson for risk averse investors.

This chart-3 shows  clearly and much better than the chart-2, that investing in 0% equity stock portfolio for long term reduces not only the probability of getting inflation adjusted return but also gives lower average portfolio return. Now, that is lot of risk in my opinion, for a Real Risk Averse Investor.

If you are really calling yourself as a risk averse investor, and feel like one, you must do the right thing by investing 15%-20% of your portfolio assets in the stock market. That is low risk portfolio. If you have fixed income securities more than 80-85% in your portfolio, you become a risk taker; you are not fit for our risk-averse tribe and your membership is cancelled, and duly excluded from our tribal gathering next time !!

Cultural Festival in Nigeria, West Africa

Happy Investing !

PS: Thanks to Vidya Bala (Funds India) who helped me with market data.

 

A ship is safe in harbor, but that’s not what ships are for.

― William G.T. Shedd

 

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