Most of the time, when people ask me to review their investment portfolio, I only see equity. This is mostly true when it comes to mutual funds. The main reason is that people don’t fully understand the benefits of having debt assets and the risk of having a 100% equity portfolio.
So in this article, we will discuss why smart investors always include debt assets in their portfolios. The main issue arises during market crashes and long downtrends in the equity market. Debt assets are a low-risk foundation for your portfolio and keep some of your investments safe. Debt assets also reduce your losses if, in any case, you have to withdraw your money, even if it is at a low value. It also reduces the volatility in your portfolio, reducing the stress you may experience due to ups and downs in your portfolio.
What Are Debt Assets?
Debt assets, in simplest terms, are those investment products where the lending of money is involved. These instruments may be traded in the market, but the interest payment generates the actual return. Some examples are,
- Bank deposits like FDs, RDs, etc.
- PPF, EPF
- Small saving schemes like Senior Citizen Saving Scheme
- Debt mutual funds (read about them in detail here)
These are only a few of the many different types of debt assets, but bank deposits, PPF, EPF, and debt mutual funds can fulfil almost all the needs of a retail trader.
Two Most Popular Myths
Whenever debt assets are discussed, their most popular advantage of risk mitigation and their usefulness in risk management is also discussed. But, in response to these advantages, two very popular responses are given; let’s discuss these two and what type of people give these responses.
- Why are you investing in equity if you can’t handle the risk? This response is very common but baffles me every time. According to these people, you either stay away from equity or should do nothing about the risk and let luck decide your future. But, in reality, we should invest in equity with proper risk management strategies.
- The stock market will go up; all you have to do is just wait. The people who give this response are either salesmen just trying to sell mutual funds or young investors who lack planning. Nobody invests just to look at their investments; these investments are done so that you can use the money in future when needed. Will you tell your child they cannot start their bachelor’s degree because you must wait for the market to rise?
Both these points are just plain excuses from people who don’t know what to do for risk management.
The most basic risk management strategies are investing in more than one asset type with different risks, i.e. one with high risk to generate returns and another with low risk to manage risk. The second strategy is rebalancing, which means rebalancing the percentage of all assets to your predetermined level. The most common combination of asset classes is equity and debt, and in this article, we will compare a 100% equity portfolio with a portfolio having 30% debt and annual rebalancing.
Equity Vs Equity Plus Debt Portfolio
Before discussing the results of comparing both types of portfolios, we should first clarify some basic parameters we implemented.
- The two portfolios are as follows, first is a portfolio where the entire amount is invested in equity. The second portfolio has an allocation of 70:30, i.e. 70% money is invested in equity and 30% in debt products.
- For equity, we have taken NIFTY 50 TRI data from July 1999 to April 2023; for debt, we have taken NIFTY 10-year Benchmark G-Sec Index for the same period.
- Rs. 1000 is invested on the first market open day of the month, and the performance of SIP has been calculated for all possible 5 years and 10 years of SIP. For example, for a 5-year investment, one SIP is from 01-07-1999 to 01-06-2004, the second is from 01-08-1999 to 01-07-2004, and so on.
- Annual rebalancing is done in the second portfolio, which means after every 12 months, the portfolio is rebalanced so that equity becomes 70% and debt becomes 30%.
- All the calculations are done on the first market open day of the month.
Now let us start our comparison for 5-year and 10-year investments.
We use the real-time data of NIFTY 50 TRI and NIFTY 10-year Benchmark G-Sec Index of the first market open day of every month from July 1999. Then we examine all possible 5-year term SIP. Now let us look at the results of the analysis of both types of portfolios.
- There were a total of 227 data points.
- The maximum return generated for a pure equity portfolio is 47.96% annually; for an equity plus debt portfolio, it was 37.28% annually.
- The minimum return for pure equity was -4.59% annually; for equity plus debt, it was -0.24% annually.
- In the case of a pure equity portfolio, five times, we get returns below 1%; in the case of equity plus debt, only once we get a below 1% return.
The same data is used to analyse the 10-year SIP of both types of portfolios.
- There were a total of 167 data points.
- The maximum return generated was 23.6% annually for the pure equity portfolio; the maximum return for the equity plus debt portfolio was 19.98%.
- The minimum return for a pure equity portfolio was 3.8%, and for an equity plus debt portfolio, it was 5.19%.
What Does it Mean?
When we look at the performance of both portfolios for both the long term and short term, we can draw some clear conclusions. Let’s have a look at these.
- The lowest return was more in a pure equity portfolio than an equity plus debt portfolio in both 5-year and 10-year investments.
- The chances of negative returns reduce very much even in the short term in an equity plus debt portfolio.
- This reduction in risk does not come for free, as the maximum return generated by an equity plus debt portfolio is less than the pure equity fund.
This gives us a clear strategy for using the debt assets; by adding debt assets to our portfolio, we can avoid low returns and negative returns to a large extent, even in the short term. It also shows us that having a significant percentage of debt assets in our portfolio for short-term investment is extremely important. But just having debt assets is not enough; in upward equity trends, your equity assets will grow so much that the percentage of debt assets will become very low, so periodic rebalancing is also necessary.
How Much Debt Assets You Should Have?
The answer to this question depends on how important the investment’s goal is and the investment’s time period. The higher the priority of your goal, the higher the debt-asset percentage, as you cannot afford negative returns. Also, suppose the term of your investment is short. In that case, the debt-asset percentage should be higher, as the chances of negative returns are higher in the short term.
- For an investment of up to 5 years: I recommend avoiding equity completely for short-term investments. But if you add equity, make sure that it is a low-priority investment, and even in this case, limit equity to a maximum of 30%.
- For 5 to 10 years: As the period increases, you can increase the percentage of equity; also, for investments where you can wait for around 3 years for withdrawal, you can have a higher percentage of equity. But keep at least 40% debt in any case.
- For 10-plus year investment: For investments of high priority like retirement and child education, you should have at least 40% debt assets; for low priority, you can have 30%. Below 30%, the benefits of having debt assets drastically reduce as volatility can’t be mitigated to a meaningful extent.
So, in conclusion, a properly planned investment portfolio should have a predetermined asset allocation, and you should also do periodic rebalance to keep the percentage of different assets at your desired value. Suppose you are completely invested in equity, no matter the time period or priority. In that case, you are only a little better than a gambler, as just like a gambler, you have let the risk to luck.