13 Sept 2020

But why is volatility in debt investment bad?

In an earlier blog post, I said this:

The way I invest—and most of us do—is to use the debt portion of the portfolio for stability while using the equity portion to bring in earnings/growth. Taking risks in debt funds for the sake of getting better returns is simply forgetting why you have an equity/debt split to begin with.

In this post, let us think about the rationale behind this principle. Before we start, let me expand on what I meant when I said “the way most of us invest”. The idea here is that:

  1. As our financial goals are approaching, we’ll be moving money from volatile investments such as equity and gold over to debt investments.
  2. By the time we want to spend the money on a financial goal, we’ll only be redeeming debt funds because 100% of the corpus for that goal should now be in debt.

My goal’s asset allocation glide path is designed in such a way that as the goal approaches, money is gradually moved from equity investments over to debt. I use my own asset allocation glide path, but if you use Kuveras goal planning, Kuvera will guide you through its own proprietary glide path. Follow the asset rebalancing advice that they regularly send, and your investments will follow their glide path. (Shameless plug: if you are new to Kuvera, sign up using my referral code JK1P3 to get Kuvera Coins worth ₹100.)

With these assumptions stated, let us look at an example. Let’s say I need 20 lakhs for my son’s college fees that’s due next month. I will have all of this 20 lakhs in debt funds, thanks to the glide path. Let’s say this is a volatile debt fund, and it loses 5% before the due date. Now the debt investment is worth only 19 lakhs! The fund might eventually recover if I stay invested for a few more months, but my son’s college will not wait. I’ll have to scramble to arrange the lost 1 lakh from some other source. This is essentially the reason for choosing a more stable debt investment over a more volatile one.

The natural question that follows is what if your goal is 10 or 15 years away and you’re not really going to spend the money any time soon? Can you invest in riskier debt funds and move them gradually to safer debt funds? You can. But then your glide path becomes complex; your portfolio will have more churn because you are not rebalancing between 2 buckets (equity+gold and debt) but 3 (equity+gold, high risk debt, and low risk debt). If you are okay with more risk, why not just invest in equity for a longer period? Your glide path remains simple and yet you take more risk in the initial days by having a larger allocation to equity+gold.

Investment is a very personal exercise. There are many “best practice” advices, but there is no single rule for how exactly to do it. Think about your desires and preferences and choose a path that’s just right for you.

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