1. Introduction to Asset Allocation
Wealth creation is, indeed, a long-term exercise. It needs continuous and planned investments. You have to be goal-oriented and need to start at the earliest. Apart from that, many other factors determine your success or failure in goal accomplishment. Merely choosing an investment vehicle based on hear-say and investing a chunk of your money is not going to serve the purpose.
It would help if you decided upon the asset allocation as well. It is a strategy wherein you plan the structure of your portfolio. You look for various assets that can be included in your portfolio. Most commonly used assets are equity shares, bonds and cash. After that, you decide how much money you will contribute to each asset. That contribution depends on your financial goals and risk tolerance.
Two individuals having the same goal may still have different allocations. The one with a higher risk tolerance may assign higher resources to equity shares. The one with a lower risk tolerance would have more of bonds in his portfolio than equity. Similarly, an investor with a short-term approach will allocate more money to bonds. The one with a long-term strategy would be more interested in equity.
2. Asset Allocation: Importance in Portfolio Management
In asset allocation, you seek answers to the following questions:
- Where to invest?
- How to invest?
- How much to invest?
It means that you identify the asset classes and the proportion in which you are holding them in your portfolio. Generally, there are three asset classes available, i.e. equity, debt and cash. 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 and subjective activity. You cannot prescribe one-size-fits-all rule.
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 investor. Especially for long-term goals, it has to be adjusted regularly as per market conditions and age of the investor. Additionally, it will also depend on the risk capacity and risk attitude of the individual.
Additionally, it will also depend on the risk capacity and risk attitude of the individual.
3. Risk attitude and Risk capacity: A prelude to asset allocation
Your overall risk appetite 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 and 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.
This is a fundamental principle concerning the relationship between age, risk appetite and asset allocation. Your risk appetite is inversely related to your age.
With each passing year, your capacity to take risk becomes lesser and lesser. It is because at a young age, your earning capacity is higher, and you can switch to better opportunities to expand income. Hence, you can replenish a couple of losses that occurred in the fund value.
However, when you are old or retired, your savings happens to be the only source of income for survival. Thus, you cannot take risks which will wipe out your superannuation savings.
4. Rule of Thumb for Asset Allocation based on age of investor
The basic principle behind age-based asset allocation is that your exposure to portfolio risk needs to reduce with age. Here, it is primarily being referred to as the proportion of equity as a portfolio component.
You can use the thumb rule, i.e. your allocation to debt funds must be equal to your age. In other words, to find your equity allocation, subtract your current age from 100. It means that as you grow older, your asset allocation needs to move from equity funds to debt funds.
Suppose your current age is 25 years. Your portfolio may be composed of 75% of equity funds and the balance (25%) among debt funds and cash. In this way, when you reach say 45 years, you can switch to equity-oriented balanced funds. These invest 65% of funds in equity and rest in debt.
Going by the thumb rule, as you approach retirement to say 60 years, you may initiate a systematic transfer plan (STP). It will move your investments gradually from equity funds to a debt fund like liquid funds. From a liquid fund, you may afterwards redeem units to meet your income needs using a systematic withdrawal plan (SWP).