Future market returns should dictate fixed income weightage

What is the ideal weight you should give for fixed income investments in your portfolio? Financial planners will say less when you are young and more when you are old. For example, a 30-year old professional should hold only 20% or 30% of fixed income in his portfolio while it should be at least 60% for a 50-year old.

Is this the ideal way to look at fixed income investments? No, it’s not. Going by one’s age and deciding how much weight to assign to fixed income investments is not the proper way to look at investments. Remember markets do not care for your age. Hence, you may be underinvested in fixed income at a time when equity markets are falling rapidly and bonds are generating equity like returns. Or, you may be overinvested when equities are doing extremely well and inflation is far outpacing fixed income returns.

As an investor, you may not care for fixed income at all and would prefer investing in equities. Or you may not care for equities at all and would only prefer fixed income. In such cases, if you only believe in equities, you should not have any fixed income investments or even if you have any, it should be of very less weight, no matter what your age is. On the other hand, if you like the comfort of fixed income and are not too keen on equities, you must at all points of time be heavily overweight on fixed income investments.

Do equity-only investors have to shift to fixed income in times of extreme stress? Yes, to a certain extent, when equity markets are going through an extremely volatile phase. Then, the shift from equities to fixed income makes sense. However, equity investors should take care to see that they do not shift out of equities at an inopportune moment. Moving out of equities at the bottom of equity prices and into fixed income at very low yields will prove counterproductive. Equities will bounce back while fixed income yields will trend up in such times.

Should fixed income-only investors hop on to equities at any point? Yes, these investors should shift to equities when equity markets are looking up and yields on fixed income securities are too low or have fallen sharply over a period of time. However, fixed income investors should shift only a part of their portfolios to equities (less than 50%) as they are inherently uncomfortable with volatility.

The right approach to fixed income is by analysing the market for potential returns. There are phases in fixed income markets where returns have been much higher than equities, the nearest case being the 250bps fall in 10-year US treasury yields over the past five years against an almost flat movement on the S&P 500 index. US treasury yields have returned an average of around 6% per year over the past five years against zero returns on S&P 500. US treasury yields at this juncture are at close to record lows and it is not the right time to be overweight on treasuries.

Indian government bond yields have outperformed equities over the past five years with bonds returning an average of around 8% per year as yields have stayed flat and the Sensex returning almost nothing. Outlook for interest rates is more positive than negative while the underperformance of equity markets suggests a bottoming out of the market. Equity investors should not shift to bonds while fixed income investors can stay invested in fixed income investments.
 

The writer is the editor of www.investorsareidiots.com, a website for investors.