Stress is a response

I used to think that external factors caused stress in me. While that may not be entirely wrong, a more correct way to think about stress is that stress is a response.

Recently, I discovered that stress is my response to what happens externally. Stress doesn’t come from outside ready-made, but rather, I create the stress within me. Thinking this way puts me on the driver seat.

Various things happen beyond my control. Responding to many of them by getting stressed is unhealthy and unsustainable. Stress starts as a mental discomfort and quickly evolves into physical discomfort.

I have long believed that taking ownership of the problem is the first step towards finding a solution. I have spent a long time blaming my problems on stress, but I think the time has come to acknowledge that I have the power and responsibility to stop stress from entering my system.

Asset allocation when you don’t have clear financial goals

I’m a big fan of goal-based investing and I’d recommend everyone to invest towards specific financial goals. But some of us cannot, or don’t want to, define goals. They just want to invest their money and get a good return. This post aims to give some guidance to such people.

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Let’s time travel back a few centuries, and imagine that you are a king or a queen of a state.  You split your citizens into 2 groups: a group of warriors and a group of residents. The Warrior group is always on the march: they go far and wide looking for new land to invade. The Resident group stays where they are and spend their days productively by farming, trading, etc.

The warriors are rapidly adding more new people to your realm by capturing new territory. (Realm, I have just learned, is the gender-neutral word for kingdom.) They are also taking a big risk: many warriors get killed in this dangerous endeavour. There is also the risk of the entire army getting decimated if they engage in a conflict with a much stronger opponent.

The residents are adding more new people to your realm too, but at a much slower pace. All the newborn babies automatically become your new subjects. Because the residents are keeping the land productive and full of opportunities, people from nearby states might also choose to immigrate into your state.

You could say that the warriors are using a High Risk High Reward strategy to expand your realm. The residents are using a Low Risk Low Reward strategy towards the same goal. As their ruler, you appreciate how each group is adding value to your realm, and understand that they are both necessary for different reasons.

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Now let’s turn to investments. You split your investment assets into 2 buckets: a Growth Bucket that contains High Risk High Growth assets such as equity, gold, etc (disclaimer: I don’t invest in gold), and a Stability Bucket that contains Low Risk Slow Growth assets such as bonds, bank deposits, etc.

Let’s say you have a surplus of ₹10,00,000 that you want to invest. You can invest the whole sum in bank deposits, but the earnings will be low and taxes high. You want to invest this money in such a way that you get to make more returns without taking “too much” risk. The difficult part is determining how much risk is too much. When you follow goal-based investing, the asset allocation glide path tells you how much risk you can/should take at any given time. When you don’t have definite goals, you have to make do with guesswork or gut feel.

There are many ways to solve this, but here are some potential approaches.

Using a fixed ratio

Let’s say, for example, you’ll invest 30% of your corpus in growth assets and the remaining 70% will be in stable assets. Over time, based on how the investments appreciate, your asset allocation will regress from 70:30. You will periodically reset the asset allocation of the portfolio to control the amount of risk you take.

If the asset allocation has become 66:34, for example, meaning 34% of your corpus is now invested in growth assets, you’ll sell some of your growth assets and buy stable assets to bring the allocation back to 70:30. This is called rebalancing, and periodical rebalancing is crucial to keep the risk of a portfolio in check.

With a percentage based allocation, the amount of money you are risking increases as the investment corpus grows. Let’s say you start by investing ₹3,00,000 in equities and ₹7,00,000 in debt. After some time, your investment corpus has grown up to ₹12,00,000. 30% of this bigger corpus, ₹3,60,000, is now allocated to equity.

This method is analogous to having your army grow and shrink in proportion with the size of your realm. Over time, the investor might want to change their asset allocation based on their needs and preferences. A salaried person might be fine with 50% of their corpus in the growth bucket, but the same person might reduce it to 25 or 30% after they have retired.

Setting an upper limit on growth assets

You can say that you’ll invest a maximum of, say ₹5,00,000, in equity. That’s the amount of illiquidity you can afford. All your regular and unforeseen expenses will be met with the money you have in your stable portfolio. Periodically, say every 6 or 12 months, you’ll sell some of your growth assets to bring the Growth Bucket back to ₹5,00,000.

This method is analogous to saying that you don’t need more than a certain number of warriors irrespective of how big your realm is. You can say that a conservative investor will choose to do this. At any point, they know how much money they are willing to risk losing or locking up in potentially illiquid assets.

Setting an upper limit on stable assets

Now you are saying that you only need a maximum of, say ₹10,00,000, for any expenses you might come across. Everything else can be illiquid, and you invest them all in growth assets such as equity. Periodically, you’ll sell your growth assets to replenish your stable assets so you always have enough liquidity to manage expenses.

This method is analogous to saying that anyone who does not need to stay at home should become a warrior. You can say that an aggressive investor will choose to do this. You keep some money aside for your immediate (and near future) needs, and everything else is deployed as risky, potentially illiquid assets.

A combination of these

You can also combine the rules above to formulate a plan that’s very personalised to your needs and preferences. For example, 50% in growth assets until your corpus reaches a certain size. When your corpus gets larger, you’ll increase or reduce your equity exposure depending on whether you want to take more or less risk.

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If you are looking to invest some money, but are not bought into the “goal based investing”, I hope this post gave you some guidance on how to think about your asset allocation.

Open-ended target maturity debt funds are an excellent choice

A few months ago, I made a blog post arguing that you should avoid volatility in debt investments. To summarise, these were my arguments:

1. When your financial goal is reached, all your money will be in debt investments. If there’s volatility in your debt portfolio, you might end up losing money. (Assumption here is that you don’t have flexibility around when you need to spend this money.)
2. It’s fine to invest in volatile debt investments as long as you’re willing to manage the volatility. For example, gradually moving money from your volatile debt investments into more stable debt investments. While doable, this is more work because you’re now rebalancing between 3 asset classes (equity, high volatility debt, and low volatility debt) instead of 2.

As a follow-up to the 2nd point, I made another blog post where I compared the performance of a volatile debt fund with a liquid fund. While you do earn a little bit more on average — say 8% instead of 7% — the volatility can cause a loss if you don’t effectively manage the risk. I recommended avoiding volatility because that’s a good tradeoff for many people. Simple is better than complex.

Recently I learned that there are some open-ended target maturity debt funds in the market. To make sense of these funds, we must first understand what “open-ended” and “target maturity” mean.

“Target maturity” debt funds invest in bonds that mature at a predetermined time. As an example, you can invest in a fund that matures in June 2026 if your financial goal is within a few months from June 2026. This fund will be volatile in the early years, but you will not be affected if you stay invested till maturity. The fund’s volatility will keep on reducing as we approach the maturity date because interest rate risk keeps reducing until it becomes nil on the maturity date. (Remember that credit risk does not reduce, so this isn’t entirely risk free.)

Fixed maturity funds have usually been closed-ended, meaning you can only invest in them during their NFO period; you can exit only at maturity. (You can buy/sell in the secondary market, but that’s not always practical.) Closed-ended funds are too inflexible to use for goal-based investing because rebalancing between debt and equity will be very hard. You want to be able to buy and sell your assets freely. In other words, you want open-ended schemes that allow you to buy and sell whenever you like.

Now that we know what “open-ended” and “target maturity” mean, let’s look at why open-ended fixed maturity debt funds are perfect for goal-based investing.

• Though the debt investment is volatile in the beginning, its volatility keeps reducing over time. This means that you don’t need to manage interest rate risk (which causes volatility), but the scheme automatically manages volatility. The only requirement is that you need to hold the investment till maturity.
• Because high duration debt usually provides a little bit more return on average, you also end up making a little bit more return than investing in a liquid fund throughout the investment period. The difference is likely not huge, but this is free money since you’re getting this additional return without increasing risk or complexity.

Right now, there are open-ended fixed maturity funds that mature in 2023, 2025, 2026, 2027, 2028, 2030, and 2031! It’s possible that AMCs will launch similar funds that mature in other years as well. You may just have to wait for some time before an AMC introduces a fund that matures at a time suitable for you.

Choose a fund that matures very close to your goal

• Do invest in a fund that matures no more than a few months before your goal date.
• Do not invest in a fund that matures much before your goal date. You’ll pay taxes on the maturity proceeds and park the money in a safe place (say a bank deposit or a liquid debt fund). This parked money will have short term capital gain that’s taxed at a higher rate.
• Do not invest in a fund that matures much after your goal. You will need to exit the investment before maturity. While open-ended schemes allow that, you’ll be exposed to volatility at the time of exit.

Reasons why I exited my gold investments

There’s a phrase that’s commonly used: “the straw that broke the camel’s back”. You keep adding straws one by one on the back of a camel and the weight keeps increasing. At one point, you add a certain piece of straw and the load becomes too much for the camel to bear. That last straw is the “one that broke the camel’s back”. Anyone that blames just that one straw is obviously focusing too narrowly and missing the bigger picture.

When I made a blog post about exiting gold, I stated gold’s inconsistent appreciation as the reason. Truth to be told, that was not the only reason. There were other reasons that were already pushing me towards exiting gold. Inconsistent appreciation was the metaphorical last straw. Here is the list of all the reasons.

• Gold is a passive asset (also known as store of value). Gold appreciates in value only when others are willing to pay us a higher price for the same gold. This is qualitatively different from equity and debt. Equity appreciates because businesses create wealth; debt appreciates because we lend capital and earn interest. The passiveness of gold made me uncomfortable.
• This is probably leaning more towards paranoia than skepticism, but I am also afraid of some scientific breakthrough making mining/refining gold cheap. Say, for example, harvesting gold from asteroids. They say aluminium used to be expensive until technology made it super cheap. How can we be sure that something like that will not happen to gold?
• Triggered by these concerns, I set out to see for myself what gold adds to a portfolio. 15% was the maximum I was willing to allocate to gold. At 15% allocation, I didn’t see that much of an improvement to the portfolio (analysis spreadsheet). There was perceptible difference for sure, but the difference wasn’t significant enough to overcome the other concerns.
• Finally, the long periods of stagnation or depreciation that I highlighted in my previous blog post.

To be clear, my stance is not that gold is a bad investment. I am only saying that I personally am not comfortable investing in gold. If you like gold, go ahead and invest in it. But know beforehand why you are adding gold. If you want to reap the benefits when gold is outperforming, you need the conviction to stay invested when gold is underperforming. If you don’t know what gold is adding to your portfolio, it’s hard to remain calm when gold is having a few bad years.

My DIY investment journey: an interim update

What does the journey of a typical DIY investor look like? (DIY is short for ‘do it yourself’ — rather than taking help from advisors or readymade tools.) I don’t know how much I can generalise, but my DIY journey has been filled with mistakes and revelations.

When I started goal based investing early in 2020, I used Kuvera’s goal planner. In fact, before Kuvera I hadn’t even heard of the phrase “goal based investing”. Within a few months, I decided to switch to DIY investing. I decided to take full control of the investments because I was just not comfortable investing without knowing the full glide path in advance. I drafted an elaborate plan using a spreadsheet with my own glide path for every financial goal I had.

Mistakes: an essential ingredient for progress?

It’s been around 8 months since then. In this short time, I have found and corrected an innumerable number of mistakes in my plan/spreadsheet. Mistakes such as not accounting for taxes. Or having too much exposure to equity. Or getting cell addresses wrong in spreadsheet formulas. Many, many such mistakes, big and small.

Some mistakes were annoying but harmless. Some were outright dangerous with a potential to cause capital loss. Despite the bumpy ride, I am pleased with my journey so far. If I had to start all over again, I’ll happily retrace the same path.

With months spent on tweaking and tuning, my investment planning spreadsheet has become sophisticated. Within the spreadsheet, I have a mini “dashboard” that shows informational and actionable data such as how much I am falling short compared expected corpus size, whether the asset allocation is out of whack, how much money to move to reset asset allocation, etc.

Asset allocation mistake

One big mistake I made was to allocate too much to equity in the initial year. Not because I wanted to, but because I made a mistake in the math. I have tweaked the plan to compensate for that mistake, but now I see that I’ll never have to buy more equity if everything goes according to plan.

The first column in the screenshot below is the year, and the second column shows the [truncated] amount I’ll be investing into equity. You’ll notice that for every year except 2020, the number is negative. This means I’ll keep selling some equity every year for 20+ years and might never have to buy more equity.

Screenshot of my spreadsheet showing that I only have outflows from equity investments throughout the rest of my investment horizon

Fixed income, not equity, is the bigger pie

Another interesting thing I noticed was how little I should allocate to equity. I am an irrationally greedy investor who wants to put as much money as possible in equity. But turns out, I should allocate less than 25% to equity in most of the years! To be honest, I am a little disappointed. I wanted to experience the violent volatility of equity, but my plan says I should invest most of the money in fixed income instead! 🙁

Screenshot of my spreadsheet showing target asset allocation. The first column is year, second column shows equity %, and the third column shows fixed income %. The big drop in equity allocation from 2020 to 2021 is not intentional. I overallocated to equities in 2020 by mistake.

This was an interesting revelation for me. This means a few things:

• I didn’t know I wanted the thrill of equity investments. Without this exercise, I wouldn’t have known that about myself.
• I pretty much don’t have to think about the choice of equity mutual funds to invest in. Redeeming equity and buying fixed income will be the usual thing I’ll be doing every year. (There will still be times when I have to buy equity for rebalancing. But I won’t have regular equity SIPs.)
• Until now, I didn’t think much about my debt portfolio because debt was a “boring” investment. My debt portfolio is also very simple with just one ultra short term debt fund. But now, I think I should pay more attention and look for opportunities to optimise the debt portfolio.
• A clarification on the previous point: complexity in a portfolio is not good, and I am well aware of that. However, I am not very comfortable leaving a big chunk of the money in one debt fund. This exposes me to fund manager/AMC risk, for example. Having more funds will help me sleep better, I think.
• Investing in more debt categories than one is also an intriguing option. I’m thinking about the options. I’ll post my plans in future blog posts as the plan solidifies.