COMPARTMENTALISE NEEDS TO PRIORITISE WHICH GOAL CAN BE PUT ASIDE IN CASE FUNDS ARE INSUFFICIENT

Having started investing in 2003, Mohnish was sitting snug and may be even smug on the profits generated in the last two years. He had just received a bonus of Rs 2 lakh, which he intended to use within six months for the construction of his house, an ongoing project. So Mohnish's question to me that afternoon as we sat in his office cafeteria was, "Which is the best place to invest these funds in?"

Most investors want to maximise returns with every single investment. The stock they buy must go up- and remain high too-from the moment it is a part of their portfolio. They almost want the stock to function like a bank deposit, but forget that the upsides also get capped if they want the risks protected.

In such a scenario, enter capital protected products. We can use financial jargon to make these products seem very complex, but I shall attempt to explain their structure. So, what is the first step to create a portfolio which will at least return capital while capturing some of the upside in markets? The first factor for consideration would be time horizon for investment. Why are we most comfortable investing in bank fixed deposits? We know that the amount invested will be paid back (with returns) after the tenure of the deposit. Let's say that you have 3 lakh to invest and do not want to lose the principal in the worst case. You do not want to ride the volatility of investing in equity markets though you do expect good returns in the next three to 10 years.

We have assumed that a fixed return instrument is available for both 3 years and 10 years at 8% p.a., and have not considered the impact of taxes. In order to get back 3 lakh (the invested amount) at the end of the tenure, 2.38 lakh needs to be locked in for three years; however, if the period is 10 years, only 1.38 lakh needs to be invested. The proportion available for investment in equities rises from 21% to 54% if the tenure is increased from three years to 10 years. If equity markets were to return 12% p.a., the return on the portfolio would be between 8.8% and 10.3% p.a.

For sceptics who do not like the connotations of the word 'equity markets', I have also worked out what would happen if the markets were to lose 10% p.a. from the time you invested. The returns on the portfolio would of course drop to between 1.7% and 4.8% p.a. But, here you have achieved your objective of protecting your capital and also taking the risks warranted to get the upside, if any, of equity markets. And we have enough empirical evidence to know that the risks in Indian equity markets diminish with passage of time: longer the period, lower the risk of getting a negative return.

Fixing tenure is important:

If you decide to keep all your funds liquid and do not want to take any risks, the capacity to generate returns would be limited. The difference between the amount allocated to equity between the three-year and 10-year investment horizon is large (21% versus 54%); and linked with that is the potential for returns too.

No risks in fixed income investing:

What is sacrosanct in these workings is the returns on fixed income. You can ill afford to have a tenure mismatch (investing in 10-year instruments when the time horizon is three years, or vice versa) as this will result in a returns variance, and throw all calculations of equity exposure into a tizzy. Further, investments must be made in government-guaranteed products or AAA rated paper so that there is limited default risk.

Reduce equity exposure as you approach your goal:

The objective of this portfolio approach is capital protection. You can review the portfolio on a yearly basis and determine the allocation to equity. That way, as you get closer to your goal, you reduce your risks. This will also result in automatic portfolio balancing and you will reduce your chances of getting caught at the wrong end of the line if markets lose all they have gained in the earlier years of the portfolio, in the last few months.

Your portfolio is actually not one composite portfolio:

It may sound ironical but not all your funds will fall into one box. You may need 5 lakh for your daughter's education after 10 years, and 3 lakh for investment in property investment in three years. My suggestion is to allocate these baskets separately. The challenge of course is to be able to compartmentalise your needs and availability; and of course to prioritise which goal can be reduced or dropped in case funds are insufficient.

On a final note, you will realise that even if your equity investments were to turn to ashes, or have zero value, your objective of protecting capital is ensured. If you invest in an instrument which in turn has spread its risk, like equity mutual funds, the chances that you will continuously lose in the long term, at least at present in India, are limited.

Source: The Economic Times, Dated: 5th Dec.2010, Page No: 6.