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Every investor aims at making profits from his investments. Investors need to choose the right stocks, fixed income instruments and other assets in their portfolio for optimum risk-adjusted returns.
Wealth creation is a long-term exercise which demands continuous and planned investments. You have to be goal-oriented and need to start at the earliest to achieve long term financial goals. Many factors determine your success or failure in goal accomplishment. Merely choosing an investment option based on hear-say and investing a chunk of your money is not going to serve any purpose.
It would help if you choose the asset allocation based on your risk profile to attain your investment objectives. It is an investment strategy that seeks to balance risk and reward by spreading assets across various categories such as stocks, fixed income instruments, cash, gold and real estate. You then decide how much money you will apportion towards each asset class.
Two individuals having the same financial goal may still have different asset allocations. The one with a higher risk tolerance may assign more funds towards equity shares rather than fixed income instruments. The one with a lower risk tolerance would have more bonds in his portfolio than equity investments. Similarly, an investor with short-term financial goals will allocate more money towards bonds and other fixed income securities. Investors would be more interested in equity-oriented funds to attain long term financial goals..
The right asset allocation is the key to all kinds of financial empowerment. Even the highest-return generating asset class such as equity funds can be of little use unless you do a prudent asset allocation. In asset allocation, you seek answers to the following questions:
You must identify the suitable asset classes and the proportion in which you are holding them in your portfolio. Generally, you have asset classes such as equity, debt and gold. You decide a ratio in which your money will be assigned to these asset classes. So, when it comes to deciding these proportions, age should be a significant consideration. After all, portfolio management is a dynamic activity which involves monitoring and reviewing the portfolio.
You cannot prescribe a one-size-fits-all rule when it comes to investing to attain your financial goals. You should know that the asset allocation changes according to the life-stages of an investor. It is different for a young investor as compared to a middle-aged or an older investor.
Additionally, it will also depend on the risk capacity and risk attitude of the individual. For instance, a young investor at the start of the career may have a higher risk tolerance and invest a significant portion of the portfolio towards equity investments as compared to an older investor. You may consider the thumb rule of 100 – age to determine allocation towards equity investments. For example, if you are 34 years old you may allocate 66% of your portfolio towards equity investments.
Your overall risk profile is composed of risk attitude and risk capacity. Risk attitude implies your psychological comfort with market fluctuations and fall in fund value. Risk capacity relates to your financial ability to tolerate losses in investment. Suppose a 30-year-old employed in a fortune 500 company earns a good salary. However, his investment portfolio is primarily composed of debt funds and money market instruments. In this case, you may consider him as a conservative investor. Although his age and financial health qualify him for equity investments, his risk attitude makes him do just the opposite.
Let’s take a look at the fundamental principle concerning the relationship between age, risk appetite and asset allocation. Your risk appetite is inversely proportional to your age. With each passing year, your capacity to take risks becomes lesser. It is because at a young age, your earning capacity is higher, and you can switch to better job opportunities to expand income. However, when you are old or retired, your savings may happen to be the only source of income. It impairs your ability to take risks with your investments.
The basic principle behind age-based asset allocation is that your exposure to investment risk needs to reduce with age. It is primarily referred to as the proportion of equity as a component of your portfolio as these investments offer a higher return at a greater risk. You can use the thumb rule to find your equity allocation by subtracting your current age from 100. It means that as you grow older, your asset allocation needs to move from equity funds towards debt funds and fixed income investments. Suppose your current age is 25 years. Your portfolio may have 75% of equity-oriented investments and the remaining 25% among debt funds and fixed income securities.
You may gradually shift from equity to debt investments as you approach retirement. It helps if you initiate a systematic transfer plan (STP) to transfer your investments. It will move your investments gradually from equity funds to a debt fund such as liquid mutual fund schemes. You may redeem units from the liquid fund at a later time to meet your income needs using a systematic withdrawal plan (SWP). You may invest in expert-curated mutual fund plans consisting of top-performing debt funds by downloading the BLACK by ClearTax app