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Why debt is a must-have in an equity-oriented portfolio?

Why debt is a must-have in an equity-oriented portfolio?

While Debt as a class of asset is known for generating regular income from the investment, equities, on the other hand, are known for growth. If a portfolio is completely made of equities, then the risk is too high and if it only consists of debt, then the investor cannot see any growth in his investment.

So, let’s find out how much debt you must-have in your equity-oriented portfolio and why you must have it.

What is an equity-oriented debt portfolio? What is an adequate Ratio of Equity and Debt?

As per the percentage of equity and debt, the portfolios are classified as equity-oriented and debt-oriented. If the ratio of equity is more than debt in a portfolio, then it can be referred to as an equity-oriented portfolio while a portfolio having more debt instruments than equity can be referred to as debt-oriented. You can simply choose an equity-oriented debt fund that has 65% of its assets invested in equities or equity-related assets as per SEBI guidelines. Now the remaining 35% of the fund’s AUM can be invested in other asset classes. When this remaining 35% is invested mainly into debt instruments, then it is known as an equity-oriented debt fund.

However, the most crucial factor is how much debt you should have in your equity-oriented portfolio. This can be understood by following the thumb rule for asset allocation as per age and risk appetite.

Risk-taking capability is inversely proportional to your age. As your age increases, the risk appetite and also capability decreases. The reason behind this is time left with you for staying invested. Suppose, you are in your 20’s, a first-time investor, usually you have at least 50 years by your side to invest but a person who is in his 60’s has only 10 years (on average). When there is more time at hand, you can take higher risks and invest in equity as much as possible but as your age increases, you should gradually shift to debt for reducing the risk in your portfolio.

Though the exact proportion of debt must depend on your investment goals, however, if you are around your 30s, then you can have at least 30% of debt in your portfolio and the rest filled with equity. As you age, this 30% should increase and when you are close to retirement, the ratio should be the other way round, that is 30% of equity and 70% of the debt.

There is a rule of 100 in investment and for asset allocation, which says you need to deduct your age from the number 100, and the result should be the proportion of equity in your portfolio. For instance, if you are 25 years old, then deducting the same from 100 results in 75. So, you can have 75% of the equity in your portfolio and the rest debt.

Additional Read: What do all first-rate wealth managers have in common?

Why it is important to keep a certain percentage of debt in your portfolio?

So, why is debt so much important in a portfolio even when you want to build an equity-oriented portfolio? Let’s see the reasons behind having debt in your portfolio.

Debt instruments help in –

  1. Lowering the risk of the portfolio: Debt instruments consist of government bonds, corporate bonds, treasury bills, and other money market instruments which are not volatile and possess very low risk. Thus, including them in your equity portfolio can mitigate a lot of risks.
  2. High Liquidity: These debt instruments if you include them in your portfolio can provide liquidity as well. They are traded in high volumes daily and thus you won’t face any issue about liquidating your debt investment.
  3. Regular income: Debt instruments provide fixed income in the form of interest or coupons at regular intervals.
  4. Adequate stability: Debt instruments not only lowers the risk of your portfolio but also make it more stable as these instruments are not so volatile.

Conclusion

For a portfolio to be rightly balanced, the ratio of debt and equity plays a vital role. Even in an equity-oriented portfolio, there has to be some debt portion to reduce its risk. Debt and equity are completely different and thus you need to bring them together as per your investment goals to strike the right balance.

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