What asset allocation best fits 10-year, 5-year and 3-year goals?

With data and inputs from Bipin Ramachandran.

We’ve written two articles so far on asset allocation. They presented data to show why 100% equity portfolios don’t work for many investors and what asset allocation one should adopt for differing return targets.  

Many PrimeInvestor subscribers – who are seasoned investors who know a thing or two about markets – asked two questions. If I can handle big draw-downs in stock markets for short periods, can I stick to a 100% equity portfolio? If I’m looking at to invest towards goals with longer horizons than 1 year, what would be the best equity-debt mix to have? This article will answer those questions. 

The main problem with holding a 100% equity portfolio is that you can face very big losses in some years. A rolling return analysis over the last 20-odd years (January 2003 to February 2024), showed that for one-year holding periods 100% equity portfolios delivered losses 18.6% of the time, with a 57% loss in the worst year. These are not acceptable odds for any investor. 

Best horizon for 100% equity

So, assuming you want to stick with a 100% equity portfolio for its high return potential, what holding period helps reduce the possibility of losses, while maxing out returns? The table below presents historical data on this. 

The main takeaways are: 

• If you are seeking a good return experience, a 3-year horizon is not much better than 1 year. Our analysis shows that by stretching their holding period from 1 to 3 years, 100% equity investors managed to halve their losses in the worst period (negative 8.3% CAGR instead of negative 57%. A negative 8.3% CAGR amounts to about a 23% absolute erosion in value) and make losses on fewer occasions (4.9% of the time instead of 18.6% of the time).

But their investment outcomes were still highly unpredictable. In its best 3-year period, the 100% equity portfolio delivered a 60.4% CAGR, but in the worst one it dished out a negative 8.3% CAGR. Holding for 3 years also meant putting up with high variability of returns (11.5% standard deviation). In 3-year periods, the equity only portfolio failed to deliver an inflation beating return (inflation assumed at 6%) about 19.4% of the times. In effect, if you invested in equities with only a 3-year horizon, the timing of your entry and exit made all the difference to whether you got to your targeted return. 

Luck plays a big role in timing, so this suggests that you cannot rely on a 100% equity portfolio for 3-year goals. A majority of equity fund investors in India exit within 3 years, so this is something for them to take note. 

• Many folks think that ‘long-term’ in equity investing refers to 5 years. Our analysis shows that 5 years is a reasonable horizon to minimise losses from equity investing. But it still doesn’t optimise risk-adjusted returns. Historically, equities have delivered positive returns for five-year holding periods about 99% of the times. In the worst 5-year period, investors suffered a 10% absolute erosion in their portfolios (compared with 23% absolute fall in the worst 3-year period. Please note these are absolute falls and not CAGR) and in the best 5 years, they managed 44 % CAGR. But then, your main objective in investing in equities is to make good risk-adjusted returns. A 5-year holding period does not guarantee this, given the Sharpe Ratio of 0.89 for 100% equity portfolios based on 5 year rolling returns (a Sharpe Ratio of more than 1 indicates an acceptable return for every unit of risk). 

• The really ‘safe period’ for investors to consider a 100% equity portfolio is 10 years. The analysis shows that folks who held equities for 10 years made a minimum CAGR of 4.1% and a maximum of 21.1%. They never experienced portfolio erosion at the end of their holding period. The variability of returns was manageable at 3.3% (standard deviation). Over 10 year periods, 100% equity portfolios beat inflation (6%) nearly 99% of the times. They also managed to get to a Sharpe Ratio of 1.75, indicating a good risk-return trade-off.    

The above findings suggest that if you wanted to gain from the high return potential of equities without relying on Lady Luck, then you had to be prepared for a 10-year holding period. To invert this, for goals that were over 10 years plus away, 100% equity portfolios without any allocation to debt or gold, worked.  

3-5 years goals - which asset allocation works here?

But what if you have only 3 years or 5 years to get to a financial goal and do not want to rely only on debt? One can well understand this need, given that debt returns seldom beat inflation and suffer usurious taxation in India. Therefore, we ran rolling returns on asset allocated 65-35 (65% equity 35% debt) and 50-50 portfolios to find out how they fared for 3 year and 5 year goals. Here’s what the data showed. 

The takeaways are:

• For investors with a 5-year horizon, a 65-35 portfolio worked quite well. It got them to average returns of 12.09% per annum, with zero lossmaking periods and a very high probability of beating inflation (over 97%). The Sharpe Ratio was also a reasonable 1.33. A 65-35 portfolio wasn’t as ideal for investors with 3-year horizons, with high variability of returns (6.7% standard deviation) and a fair chance of not beating inflation – 12.5% of the time. 
• For investors with a 3-year horizon, a 50-50 portfolio worked better. While returns averaged 12.08%, there was only a 8.46% chance of not beating inflation. The Sharpe Ratio was 1.18. 

However, the above results also go to show that if you include equities in a portfolio meant for a 3-year or 5-year goal, there is an off-chance that your returns will be in the single digits. The above data shows that the worst-case scenarios on these portfolios over 3- and 5-year holding periods, at a negative 0.5% CAGR (65:35 equity debt portfolio)  and 1.69% CAGR (50:50 equity debt portfolio), would have left investors very disappointed and well short of their targets.

The message is that allocation to equities can bump up your returns over 3 or 5-year periods. But if you’re unlucky or time your entry or exit badly, your returns can leave you disappointed too. This argues for being careful about equity allocations for upto 5 year goals, at the peak of a bull run.  

Our earlier articles on this subject:

What is the best asset allocation?

Will an all-equity portfolio work?