personal finance

How to use Cap Curve to build a solid portfolio of equity funds?


Asset allocation is an investment strategy that aims to apportion an investor’s assets according to his/her goals, risk tolerance and investment horizon.

How should an investor allocate money across the cap curve? The cap curve in a nutshell captures the presence of companies with different levels of market capitalisation.

Market cap is a simple measure of value that a company obtains by multiplying the number of shares issued by the company with its stock price. Stocks are broadly classified as largecaps, midcaps and smallcaps.

Why does this question crop up frequently? The reason is likely returns, risk and liquidity differ significantly and they have significant implications for asset allocation. To get an insight into money allocation across stocks of different sizes, it is important to have a clear understanding of market-cap profiles of different stocks.

Largecap stocks provide a higher degree of comfort and are less vulnerable in a difficult economic environment. As risks can be higher and liquidity lower in midcap and smallcap stocks (potential returns are also higher), it is important for investors to know the market-cap of a company whose stock they are buying or the market-cap profile of the fund in which they are investing.

This information is usually available on multiple sources (NSE/BSE for stocks and websites like Economictimes.com for market-cap profile of funds, to name a few).

What influences an investment decision

This allocation decision depends on several factors such as age, income, wealth, risk appetite and liquidity preference. These factors are also interlinked, and hence it is not easy to make a precise allocation decision that can be used as a model by every investor. If you ask guidance from five different persons on this allocation decision, it is likely that you will get five different answers.

The one aspect that can be used by a vast cross-section of investors is age. As you advance in years, after a stage, a greater proportion of your money in equity should be in largecap stocks/funds. This is important, as the ability to take risk and absorb losses tends to decline; this is true for even persons with high net worth, as they also need to avoid the major hiccups that could disturb peace. In this backdrop, let us outline a road map that could serve as a guidepost to allocation.

Starting portfolio: Each of us should start disciplined investing at an early age. Depending on job profile, this may typically be at the age of 23-30. When you start a portfolio, it is better to have almost a large-cap focus. Why? You need to build a portfolio that can over a five-year period become a sizeable core investment.

At this starting stage, exposure to midcap funds may not be advisable as if you are unlucky to run into a corrective phase in the market and/or a bad patch for the economy, this component could take a bigger beating. In such an eventuality, your portfolio will suffer significantly at an early stage.

It could also affect your confidence as an investor and impair your risk-taking ability at precisely the wrong period of an investment lifetime. Even if you have gumption to stick it out in equity, you could refrain from midcaps or get into them only at an extended stage of a bullish phase; both will detrimental to long-term wealth creation.

If you focus on largecap equity funds at this early stage, you could expect to build a core portfolio without too many hiccups. Even if the economy and markets go through a lacklustre phase, largecap companies, stocks and funds tend to be more resilient. This may also be a period when people now tend to plan for homes. In this context too, a largecap-focused start will be a better way to build a kitty to make the down payment.

The more important aspect is, however, the role that such an approach can play in your long-term allocation decision. Once you build a decent-sized largecap portfolio, you are in a better position to add a riskier component, namely midcap funds.

Even when you shift a part of your investment to midcaps, it will account for only a small part of overall portfolio. This will improve your comfort level in investing more gradually in midcap funds.

A five-to-seven year time frame will also definitely be marked by a substantial increase in income levels. That will also enhance your level of investment and make for a comfortable passage into midcap funds. During this period, it is important to stick to the plan even if you find midcap stocks going through the roof. Your time to participate in wealth-creation by midcaps lies ahead at the next phase of your investment lifetime.

Middle-age portfolio: The years 30-45 should be your window to spreading your investment across the cap curve. If you are very conservative and avoid midcap funds, you could miss out on the superior returns likely in the midcap space over a 10-15 year period. More so in an economy like India, which offers opportunities for companies to grow significantly in scale.

An allocation to midcaps is important in India, as they could deliver significant premium to

returns from the large-cap space, and so midcap funds must be an integral component of every intelligent portfolio.

At this stage, you are better placed to embrace the high-risk, high-return universe of midcap stocks and funds. Gradually step up your allocation to the midcap space.

Depending on your wealth, income and risk profile, you can consider owning 20-40 per cent in midcap funds towards the middle of this phase. This will provide a more aggressive tilt to your portfolio and create space for higher returns. If you are more risk averse and/or do not have very high incomes or wealth, stay with an allocation of about 20 per cent to the midcap space.

During this stage, you will continue to add to your investment in largecap funds. Do not make the mistake of moving completely towards midcap funds even at this stage. You must attain your target allocation for the midcap space in a phased manner over a three- to five-year period. This will give a window of 10-15 years to reap benefits from your exposure to this cap-curve category.

Preparation for retirement: The age of 45 may appear too early a stage to contemplate a switch in allocation and plan the portfolio for your retirement. It may, however, be the more appropriate time to make the switch in approach, even for investors who plan a retirement at 60, and not earlier.

This will allow a good 10-15 years for your portfolio to grow further in value and overcome any lacklustre phases in the economy and markets.

If you leave this tactical shift to a later stage, you may suffer if the economy/markets go through a rough patch or a bearish phase closer to your retirement date.

At this stage, do not move out of equity. That would not be advisable except for persons with a small kitty. This is the phase when you must shift again to largecap funds to ensure your incremental investments are in the most resilient space of the cap-curve – funds tracking largecap stocks. This shift will also achieve another purpose. It will whittle down the midcap component from the 20-40 per cent suggested levels (and a bit higher, too, if they have delivered the goods by way of superior returns) and reduce the overall risk of the portfolio.

Retirement home stretch: This is usually the phase between 55 and 60 or 60 and 65. Your allocation decisions at this stage must shift ground significantly. Your planned investing in equity for about 30 years should ensure your savings have grown at a healthy rate. With the benefits of compounding over a long period, the value of your portfolio should be significant enough to leave you in a comfortable position for retirement, enable you to sustain your lifestyle and possibly leave a legacy to your children.

Do not move out of equity completely at this stage, too. Today, life expectancy is in excess of 70 and only rising. This means your portfolio must be able to generate inflation-leading returns for longer periods and to do so, you need an equity component

Depending on your net worth, reduce your equity exposure to between 20-40 per cent of assets. The rest of your equity portfolio must be moved to fixed-income assets using tax efficient and low-interest-rate risk options. This will ensure that your investment pays off when it must and you significantly lower risk of your portfolio.

Portfolio beyond retirement: Retain an equity component of 10-30 per cent depending on your wealth and risk appetite to ensure that there is an element that can boost your overall portfolio returns so as combat inflation.

The crucial question: Should this approach be tweaked based on market conditions – be it moving out of equity or in and out of midcap funds. If your investment plan is long-term, avoid trying to link the decisions to market conditions (to get an idea of the futility of timing, refer number-based insights on the cover page of this publication) except in two situations:

  • If the market reaches extremely outlandish valuations – as was the case in Japan in 1989, Nasdaq in 2000, Taiwan in the late 1980s or tech stocks in India in early 2000 – consider a tactical shift out of equity.
  • If you are in the retirement homestretch and get unlucky with a bearish phase, do not cut equity except to extent required by circumstances. Wait it out for a few years to reduce exposure in a more favourable market environment. You could also reduce equity by three-five percentage points each year after age of 50 to ensure you exit at different levels of the market.

This is a broad outline of allocation for the equity part of your portfolio. This will have to be tweaked based on factors such as income, wealth, risk appetite and liquidity preference at every stage and this must be reviewed every year. Along the entire way spanning 35-45 years, have realistic expectation of returns (closer to what markets provide as a long-term average, even if you get outsized returns in a few years like in 2003-2007), a long-term approach and a willingness to stay invested at all times. Do not forget to have a well-planned fixed-income portfolio through the entire period. Remember what we have discussed is only for the equity component of your portfolio.





READ SOURCE

Leave a Reply

This website uses cookies. By continuing to use this site, you accept our use of cookies.