Portfolio Balance Model - A Case Study

“Balance is beautiful.” ~Miyoko Ohno

portfolio balancingThose who all maintaining an investment portfolio naturally have two question to get answers. First, “how do it balance upon age?” and next, “what are the investment instruments to balance the portfolio?” This article originally wrote to give a perfect answer to the first question, How do one balance portfolio based on age?

However, before starting this article, I would like to give a simple, understandable answer to the possible second question “What are the investment instruments to balance the portfolio?”. Answer to this question is really simple. A portfolio balancing is an act of including high risk investment instruments like stocks, mutual funds, commodities and low risk instruments like fixed deposits, mutual fund fixed maturity plans in a correct proportion depends on the age and risk taking capacity of the person who builds the investments portfolio. It clearly tells, a portfolio should have a right proportion of two candidates, high risk investment instruments and guaranteed investment products.

Portfolio Balance Model - A Case Study

Portfolio balancing is an action to balance the instruments from both, high risk and guaranteed, by adding or removing upon the age and risk profile of the person time to time. Other than age and risk profile, there are various factors influencing the balancing act but these two are important than any.

I have already posted an article with Money Hacker earlier but, though I will clarify little more to give better understanding to readers than the original article. Let us move to the core of this article. We are starting with the financial experts Golden Portfolio Balancing Rule: “Reduce your age from 100. Resulted percentage of your total money should go to the high risk, high growth investments and rest should invest to guaranteed instruments”.

I know you have not understood anything. So I will clarify this with a simple example. Suppose you are in the age of 25 and planning to create a portfolio with mix of high risk investments and guaranteed investments. To identify how much percentage you need to invest on both instruments, you are reducing your age of 25 from 100 and getting a result of 75. With this result, you are investing 75% of your money to high risk investments like equities and equity mutual funds or commodities or whatever it is. Rest 25%, i.e. the percentage similar to your age, of money you are investing to the guaranteed instruments like fixed deposits, traditional insurance policies government secured papers etc., and you are now very happy because you have got a well balanced portfolio upon your age and what expert financial planners recommending.

I know you have not understood anything. So I will clarify this with a simple example. Suppose you are in the age of 25 and planning to create a portfolio with mix of high risk investments and guaranteed investments. To identify how much percentage you need to invest on both instruments, you are reducing your age of 25 from 100 and getting a result of 75. With this result, you are investing 75% of your money to high risk investments like equities and equity mutual funds or commodities or whatever it is. Rest 25%, i.e. the percentage similar to your age, of money you are investing to the guaranteed instruments like fixed deposits, traditional insurance policies government secured papers etc., and you are now very happy because you have got a well balanced portfolio upon your age and what expert financial planners recommending.

Wait a minute…. There is a really confusing, hidden problem with this calculation:

From the mouth of experts, people should build and balance their portfolio when younger. But, when he reaches to the age of retirement, his portfolio should have maximum debt and minimum equity exposure. i.e. 90% debt and only 10% equity.

Suppose, now your age is 25. Subtracting 25 from 100 will result 75. In that case, your portfolio should have 75% of equity exposure and 25% in debt instruments. I agree.

As per the balancing advice, you have invested 75% of your amount to the equity/other high risk investments and rest 25% to the guaranteed instruments. To ensure your portfolio is well balanced upon age, you required balancing portfolio each year by decreasing or increasing equity and guaranteed instruments depends on your age. If you are in the age of 25, your equity exposure would be 75% and debt exposure is 25%. When you reach to the age of 45, your equity exposure should be 55% and debt exposure is 45%.

OK. You are reducing your age from 100 in each year to identify the equity and debt proportion to your portfolio. Now you are planning to retire at the age of 55. With your present plan, when you are reaching to the age of 55, your equity exposure would be naturally 45% and debt exposure is only 55%. Then how this rule will work for you? As per this golden rule, a person at the age of 25 requires an equity exposure of 75% and debt exposure of 25%. Also saying when he reaches to the age of your retirement, here it is 55, his equity exposure should be only 10% and debt will be 90%. In reality, it is showing 45% equity exposure and 55% debt instruments instead of 10% and 90%!!!!

Confused? !!! Below is your best answer to clear this confusion but with the help of little mathematics…

Can you identify the mistake you have made here?

Yes, the mistake you have made is, you have just obeyed the Golden Rule without trying to understand the reality or intention behind this rule. You have ruled with simple calculation each time, by reducing your age from 100, to understand the equity and debt proportion required by portfolio to balance. But you have forgot a truth, by following this rule blindly, you are required to reach at the age of 90 to retire with a portfolio of 10% equity and 90% debt!!!!

Of course, the next question or doubt will be, what is the above said ‘reality’ or ‘intention’ with this rule?

Here is a case study with full clarification on how a model portfolio balancing done exactly to get a perfect result. You must read the scenario below to have better understanding on this:

Scenario: Your age is 25 and your initial investment is 1 lac. We will first balance this 1 lac investments between equity and debt in the correct proportion from the age of 25, till the age of 55, you are planning to retire. The ultimate result at the age of 55 is 10% in equity and 90%. See how the portfolio balancing works:

portfolio balance modelI know, you are curious to know about this calculation. Below is the calculation details. You can use MS Excel to do your own calculations to realize how I have done it!!

An individual aged 25, carrying a total amount of 1 Lac investment portfolio till the age of 55. He should invest 409090.91 in debt and 590909.09 in equity at his age of 25.

Debt investment amount calculation formula is: Total Amount*Age/55 and reducing 10% from the result. This 10% ultimately come as your 10% equity exposure at the retirement age of 55.

Equity investment calculation made by the formula: Total Amount - Debt (received as per above calculation)

Example:

Debt investment: 100,000*25/55 = 45454.45 and deducting the 10% from this amount will give the Debt investment value of 40909.09/-

Equity investment: 100,000 – 40,909.09 = 59,090.91/-

This example applicable to 1 lac worth investment portfolio that a person carrying from the age of 25 to 55, until his retirement. If you make slight alteration to this portfolio, you will be able to calculate any amount, at any time adding to your portfolio at any age.

Appreciate your own view on this article. I welcome and happy one your suggestions, queries or even doubts to clarify, as the form of comments under this article.

Those who are interested, can download a portfolio balancing excel sheet created by Mr. Nikhil Shah, with more features.

Picture: clairity

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