Should You Go For All-Equity Portfolio?

Our analysis shows how an all-equity portfolio performs compared to all-debt and 50 per cent debt and 50 per cent equity portfolio. That done, the choice is clear: those who are not in favour of too much volatility should preferably opt for a balanced portfolio

Ever seen a house of cards collapse? Well, that exactly what it seemed like in March 2020 when the equity markets witnessed a swift decline. However, from then on there has been good recovery. In fact, presently the frontline indices are at their all-time high level. In the month of March 2020, S & P BSE Sensex registered a low of 25,638 and from there it went all the way up to 44,825 to make a record high in just a matter of few months. This recovery was so quick that many investors started moving to an all-equity portfolio. In fact, it even led to a huge spurt in the opening of new demat accounts. So, should you have an all-equity portfolio? But before we tackle this question, let us have a look at the journey of S & P BSE Sensex from 1980 till today.

The above chart clearly depicts a rosy picture about the equity market. You may say that in all ways it makes more sense to have an all-equity portfolio. Even S & P BSE Sensex’s compounded annual growth rate (CAGR) for this period was 15.84 per cent. It therefore seems to be a foregone conclusion to have an all-equity portfolio as the long-term return too seems to be quite healthy. In order to understand this, let us take the one-year, three-year, five-year, seven-year and ten-year rolling returns for the period 1980 to 2020. Further, we would also understand its risk via standard deviation.

As is seen from the chart, the one-year returns seem to be quite volatile. Therefore, if you are planning to invest in equity for short-term, then we would say that’s a bad idea. You can just trade in the short-term period but if you want to invest then it should always be a long-term proposition.

Even the three-year rolling returns show quite a bit of volatility. In fact, many a time returns were in the negative trajectory. This is when a three-year period is considered to be long term for equities.

Even when we look at the five-year rolling returns, though the number of negative instances has dropped, we can see that there were quite a few of them. For large-caps, a five-year period is long term enough.

The seven-year rolling returns tell the same story. The instances of negative returns have declined, but still you cannot overlook the fact that there are negative instances. A seven-year period is something that we consider as long term for most of the mid-caps.

In the 10-year rolling period, we can see only one negative instance. This indirectly means that to have no negative instances from your equity investments you need to invest for more than 10 years.

Also, from the above graphs you might have noticed that in all the rolling returns’ period there were some chances of witnessing negative instances. This means that if you have an all-equity portfolio, you should also be ready for the shocks that they carry. Furthermore, you also might have noticed that though there are fewer negative instances when we notch up the rolling returns period but at the same time the returns that you can expect keep diminishing. Previously, you would be getting returns between 30-40 per cent but now it is somewhere between 15-20 per cent.

The above graph shows the five-year rolling standard deviation of daily returns of S & P BSE Sensex. Standard deviation is a measure of risk. It is assumed that higher the standard deviation, higher the risk. Also, higher the risk, higher your expected returns. In the above graph, you can witness that the standard deviation of equity is falling. This means that the volatility in the market is nose-diving. Therefore, risk is low, but returns are also low. You may also notice that even the fall that was witnessed in March 2020 did not help the standard deviation to shoot up to its previous highs. Therefore, in an all-equity portfolio you have a risk of earning potentially low returns. Having said that, the risk involved in equities is still quite high than that of debt.

The above graph shows you the performance of an all-equity portfolio, all-debt portfolio and 50 per cent equity and 50 per cent debt. With this, you might feel that with all things considered an all-equity portfolio is still better than others. But this is just the returns’ part. Now let us look at the risk as well as risk-return metrics.

As can be seen from the above table, the standard deviation of an all-equity portfolio is way higher than an all-debt portfolio and 50 per cent equity and 50 per cent debt portfolio. In the case of risk-return metrics like Sharpe ratio and Sortino ratio, an all-debt portfolio is better followed by 50 per cent equity and 50 per cent debt portfolio. Therefore, it seems that it makes a lot of sense to have a balanced approach rather pitch for the extremes. You should balance your portfolio in such a way that will give you higher returns with low volatility.

Taking into consideration all the above factors, every investor has a different appetite to digest volatility and therefore asset allocation based on risk profile is the best approach. The risk profile ranges from conservative to aggressive. Investors with a conservative risk profile cannot stomach volatility and hence they opt for less allocation to equity. Their asset allocation would look like 20 per cent equity and 80 per cent debt. On the flip side, an aggressive investor can stomach a lot more volatility.

Therefore, his asset allocation would be 80 per cent equity to 20 per cent debt. Further, one can link asset allocation to market valuations. Higher valuation attracts less equity and more debt, while lower valuation attracts high equity and less debt. In order to do this, you need a sophisticated tool such as ‘equity sentiment index.’ This is a proprietary tool designed by DSIJ’s MF Research Desk.
As is seen, our proprietary equity sentiment index has given better entry and exit calls. Even the recent valuation is moving quite high. But the point is that this is one of the sophisticated tools that investors can consider if they wish to manage their asset allocation dynamically. Further, we have an all-equity portfolio option too but that is a very rare situation when the markets are deeply undervalued.

Conclusion
An all-equity portfolio is not meant for everyone. Our analysis above shows how it performs compared to all-debt and 50 per cent equity and 50 per cent debt portfolio. Though in terms of returns it does well but when it comes to risk it is riskier than that of all-debt and 50 per cent equity and 50 per cent debt portfolio. Even an all-equity portfolio is not able to stand against other studied portfolios in terms of risk and returns metrics such as Sharpe ratio and Sortino ratio. This shows that it doesn’t seem a better option as it is not able to generate adequate returns for the risk undertaken when compared with all-debt and a balanced portfolio.

Therefore, only those who are able to withstand the force of volatility should go in for an all-equity portfolio. Further, such investors should have a pretty long-term investment horizon of say 10 years or more. Moreover, our study only includes the large-caps for understanding purpose. The volatility in mid-caps and small-caps would be way higher than that of large-caps. Hence, it is always prudent to diversify your investments across asset classes such as debt, equity, gold, real estate, etc. This will help you to generate optimal returns by properly managing the risk.

“A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies.”

-Harry Markowitz