Why investors must have a debt instrument in their portfolio despite having relatively lower returns than equities.

The Story

In investing, equities often steal the spotlight, as they come with the potential for high returns.

In contrast, debt investments like fixed deposits or bonds might seem… well, boring. But here’s the thing: these are also a necessary ingredient in your portfolio.

Returns are something you, as an investor, cannot control. Markets fluctuate, economies shift, and no one has a crystal ball to predict the future.

However, what is in your control is how much risk you’re willing to take. And this is where debt investments play a crucial role. Here’s how.

How does debt safeguard your portfolio?

Debt investments have historically been less correlated with equities, meaning equity and debt are less likely to move in the same direction.

For example, when equities gain, debt instruments like bonds often remain steady, offering fixed interest.

On the flip side, when equities drop, investors often move to safer options like bonds as they offer fixed returns, increasing their value during downturns.

The correlation turned negative from a high positive during the 2008 and 2020 crisis. Meaning, during these times, debt investments gained when equities fell.

It shows that when equity’s value falls, debt might remain stable or even rise, which helps balance the overall portfolio and minimizes the impact of individual losses.

Overlooked benefits of debt investments

Adding debt investment will not only diversify your portfolio, it allow you to rebalance your portfolio. It involves periodically adjusting the assets to ensure that debt-to-equity allocation is maintained.

When equities fall, rebalancing can benefit by buying more stocks at lower prices, thus taking advantage of market declines.

The idea is to shift your investments between stocks and bonds to maintain a target balance. This strategy helps you buy low and sell high, increasing your overall returns over the long term.

Apart from that, while equities are for wealth creation, debt is for wealth preservation. Investments like fixed deposits, liquid funds, and ultra-short-term funds have higher liquidity and are considered ideal for parking emergency funds. So the real advantage of having a debt investment can only be seen in falling markets and rainy days.

To Conclude

It is like salt–might not stand out when it’s there as it offers lesser returns, but its absence could leave the portfolio lacking stability and liquidity.

Though debt mutual funds are relatively safer, they carry their own set of risks. The key is to ensure that your debt investments align with your risk tolerance and financial goals.