Where to Invest?

Where to Invest decisions and how you allocate your portfolio among the 3 main asset categories - stocks, bonds, or cash (money market funds and short-term FDs) has a great impact on your investment portfolio's long-term performance. Infact my seniors tell me, this impact over the long-term is far greater than any specific investment decision (like investing in XYZ stock) you might ever make.

Where to Invest: Asset allocation is important because it has a major impact on whether you will meet your financial goal. If you don't include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal. For example, if you are saving for a long-term goal, such as buying your dream house, most financial experts agree that you will likely need to include at least some stock or stock mutual funds in your portfolio.

On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it. A portfolio heavily weighted in stock or stock mutual funds, for instance, would be inappropriate for a short-term goal, such as saving for the family's Europe trip, next summer.

Now look at this in another way. Let's say you have followed basic investing principles well, and in particular are well-diversified within each asset category, you would have eliminated most risks associated with any single investment. However, you could still end up not meeting your financial goals if you got your where to invest: asset allocation wrong.

For example, let's say you have a nice diversified portfolio of 20 stocks. Your decision, several years ago, to invest in Wipro rather than Infosys may have caused you to kick yourself once or twice, but this would have cost you far less than a decision several years ago to invest only 20% of your total portfolio in the stock market, and the rest in cash investments.

So, we are clear now how important it is to get your Where to Invest decisions, or your asset allocation right. Great! But how do you go on to make the right where to invest: asset allocation decisions for yourself? There are two components that can help you in this decision making process.
1. Historical returns/risks associated with the 3 major asset categories, and
2. Your own Investment profile

Balancing these risks and potential returns based on your investment profile, will lead us to the right where to invest decisions.

Historical Returns

We never know what the future will hold. But we do know the past. We sure can use historical data from the past to serve as a guide for our where to invest decisions, provided we remain aware of the limitations.

Fistly, the past may not be repeated, we should be fully aware of that! Second, it is important to look over enough of the past to cover various economic and market conditions. Yet avoid extending so far back that we view conditions that may no longer be applicable due to structural changes in the economy.

I couldn't get data for the Indian stock market extending so far back, so I have used S&P 500 index data from 1946-2004, as presented below. As I looked at this data and tried to interpret, it's clear to me that similar where to invest conclusions will hold for the Indian markets as well.

So what are these where to invest conclusions?

I thought it best to include the following data, analysis & interpretation based entirely on an American Association of Individual Investors (AAII) article.

The where to invest stock data presented here covers the Standard & Poor’s 500 index, which consists of larger, established companies. The bond data is for intermediate-term government bonds, with a maturity of about five years. Cash is represented by Treasury bills, the most conservative segment of the cash investment market. This where to invest data represents the core areas in which most investors will concentrate, but there are more volatile segments of each category - small stocks and longer-term bonds, for instance.

The where to invest data includes annual returns for the overall period, as well as annual returns based on 1, 5, 10, and 20 year holding periods, to indicate how the risk/return equation can change with time. (These holding period returns encompass all the years using rolling holding periods. For instance, five-year periods include 1946 through 1950; 1947 through 1951, etc.). The data also indicates the percentage of holding period returns that were losses, and the percentage of holding period returns that were below the rate of inflation.

Using the where to invest historical data, you can start to get an idea concerning the risks and potential returns of the three major asset categories.

Market risks

Both stocks and bonds face substantial market risk - a rise or fall in the value of the investment due to market conditions. A good indication of market risk is to simply examine the best and worst returns over one-year holding periods. Those returns were the kinds of variations that may occur within that category.

Stock market risk is due to the volatility of the overall market, which can cause even reputed stocks to drop in price. For one-year holding periods, stock returns were extremely volatile (and therefore uncertain)- ranging from a high of 52.6% to a low of –26.5%, a substantial loss. In addition, 24% of the one-year holding periods’ returns have been losses. Stock market risk for stocks does decrease with longer holding periods, as the longterm growth benefits kick in. Check out the 10 & 20 yr holding periods.

Bonds also face substantial market risk due to fluctuating interest rates; this risk is referred to as interest rate risk. Rising interest rates cause existing bonds to drop in value, while falling interest rates cause existing bonds to rise in value; the effect is greater the longer the maturity of the bond. Interest rate risk has caused intermediate-term bond returns to range between 29.1% and –5.1% for one-year holding periods, and suffer losses 12% of the time for one-year holding periods. Interest rate risk decreases only slightly as the holding period increases.

Cash investments face no market risk because their return is solely based on their current yield.

Inflation risk

All investments face inflation risk - the risk that inflation will erode the real value of the investment. There are two good indications of inflation risk: an investment’s real return (its return after inflation) and the percentage of holding period returns that are below inflation.

Stocks face the least inflation risk. Over the entire period, they have produced an annual real return of 7.5%. In contrast, bonds have outpaced inflation by only 1.8% annually, and cash by only 0.5%. Individual holding period returns also indicate the substantial inflation risk facing bond investments. For one-year holding periods, bond returns were below inflation fully 44% of the time; for longer holding periods, inflation risk was similar for bonds and cash; stocks suffered the least.

Please spend some time over the table above. It summarises quite well the where to invest risk/return characteristics of the 3 major asset categories, and thus what you can or should do, about them. I am re-emphasising these where to invest characteristics for better effect!

1. To beat inflation risk over the long term, there is no alternative but stocks.
So if you are investing for a future event that's 10 or 20 years away (buying a house, child's marriage/education, retirement) - you gotta be invested in stocks or stock mutual funds. So you need to take higher risks with some part of your portfolio for these kind of requirements. Else, inflation would have eaten away all your returns!

2. To reduce liquidity risk, some portion of one's portfolio has to be in Cash,
cash equivalents (money market funds, short-term, medium-term FDs). This would mean if you need cash urgently, you might not need to sell out of stocks or stock mutual funds at inopportune moments at a loss.

3. To reduce business risk, one's stock or stock mutual fund investment portfolio needs to be well-diversified.

4. To reduce stock market risk one should invest in schemes like the Public Provident Fund and other such government-backed investment schemes in India, like NSC and KVP schemes.

But all these, are on an individual asset category basis. A more efficient approach is to weigh the risks and return potential of your overall portfolio, not just the individual parts. Diversifying among the asset categories reduces the individual category risks and allows you to build a portfolio that matches your investment profile.

Your Investment Profile

As discussed at length before, your investment profile includes your tolerance for risk, your return requirments, your time horizon, and your tax exposure.

So let's see how can we go about using the data above to build a where to invest portfolio - allocate your assets with the right balance - that can meet your return requirements without exceeding your tolerance for risk.

Risk Tolerance
We can use the worst-case scenario - the maximum loss for all categories - as a guide to how much of a loss you can stomach. In the examples below, I have used the worst one-year holding period returns.

Return Requirments
We can use the average annual returns for the entire period, average annual growth and the average income figures to help put a perspective on what you can expect on your growth and annual income requirments, but keep in mind these are long-term figures; variations year-to-year can be significant.

With the background set, we can now examine various possible asset category combinations to see how they might fit your personal investment profile. We will use the
risk and return characteristics of the individual categories to help you decide what to emphasize. Then we will examine the risk and return characteristics of the total portfolio.

Portfolio 1 is heavily invested in stocks, which indicates that this is for a long-term investor with a primary need for long-term growth that outweighs the short-term stock market risk considerations. The overall characteristics of the portfolio reflect the investor’s profile: a high tolerance for risk (the downside risk is –21.2%); less emphasis on annual income; and a higher requirement for growth return. This portfolio tends to match an aggressive investor, or the characteristics of many individuals in their early, or mid-career stages of the investing life cycle.

Portfolio 2 is suited for a more moderate risk taker, with a downside risk of –16.9%. The trade-off is ofcourse lower growth.

Portfolio 3 stresses a higher annual income and lower downside risk. The trade-off again, is considerably lower growth. This portfolio tends to match the characteristics of a defensive investor, say someone in early retirement.

And, there are some investors with a portfolio completely devoid of stocks - only bonds and cash. These are the ultra conservative investors for whom capital protection is a must. This kind of portfolio matches the characteristics of someone in late retirement.

As is evident, you could use several combinations to match your specific individual profile - your unique risk tolerance and return requirments. Each individual is unique and one's asset allocation could potentially use any combination to achieve the needed balance between return requirements and risk tolerance.

If you want to play around with other combinations, you can use the formulas as mentioned above. Have fun!

You now probably have a rough idea of your overall where to invest: asset allocation decisions. Equipped with this, you can now go on to make selections within each asset category - while maintaining this broad allocation across asset categories.