Stabilising equity portfolio with debt MFs

There is no doubt that in the long-term, equities have more potential to create wealth for you. Besides, everyone has their own definition of long-term. From capital gains tax standpoint, holding equity investments for more than one year is considered to be long-term. However, for some investors, it can be 3 years, 5 years, or even higher, depending upon their risk appetite and the type of equity funds they are holding. For instance, someone investing in a large-cap fund might consider three-year as long-term whereas, for an investor in a small-cap fund, it might be more than 10 years. Furthermore, it is quite difficult to predict whether you are in the middle of the bull or bear run or is it about to end. Therefore, it is quite possible that your portfolio might turn wobbly. Hence, in order to stabilise your equity mutual fund portfolio, debt funds come to the rescue. This is what asset allocation means. 

What is asset allocation? 

Asset allocation is nothing but investing in multiple unrelated asset classes to avoid unnecessary risks. Thus, investing in debt along with equity in the long-term might help you create wealth with proper risk management. 

How debt stabilises the equity portfolio? 

In order to understand this, we would be taking help of an illustration wherein, we would be looking at the stability of returns in 100 per cent equity portfolio, 70 per cent equity and 30 per cent debt portfolio, 50 per cent equity, and 50 per cent debt portfolio, 30 per cent equity, and 70 per cent debt portfolio as well as 100 per cent debt portfolio. Besides, we have assumed Nifty 500 Total Returns Index (TRI) and CCIL All Sovereign Bond TRI as representative of equity and debt, respectively. The period of study would be from April 1, 2011 to March 30, 2021, where we would be calculating the five-year rolling returns of all the above-mentioned portfolios. 

After looking at the above graphs, you might feel that having a 100 per cent equity portfolio seems to be the best option. However, this way, you are just looking at its returns and how it has beaten other portfolios in the rising market. However, if you look at the period from March 2019 to March 2020, then the 100 per cent equity portfolio was underperforming other portfolios. In fact, out of 1,238 five-year return observations, there were four such five-year periods, where 100 per cent equity gave negative returns, while other portfolios had no negative return instances. 

Now you might say that, out of a large number of observations, four observations are quite negligible. True that! So, in order to move them through a stringent test, let us check how many such instances took place, where these portfolios could not beat the inflation. We have assumed inflation to be 7 per cent. 

As we can see in the above graph, 100 per cent equity portfolio failed 9 per cent of the time to beat inflation. However, when you add debt to the equities, the chances of the same reduces. Therefore, we can comfortably say that debt funds indeed help to stabilise the equity portfolio.