Asset Allocation: Are there any Thumb Rules?

The famous phrase in personal money management “Don’t put all your eggs in one basket” especially speaks about diversification of our wealth across various asset classes depending upon our own requirement, financial goals, risk appetite and various other factors. While diversification of assets ensures the mitigation of risk associated with each asset class, on the other hand, it also reduces the expected return from the respective asset class to a certain extent.

When wealth is concentrated within few asset classes, risk and return both are high. And, if wealth is diversified across various asset classes, it reduces both risk as well as return.

Usually, asset classes can be seen as equity, debt, gold, art, commodities, and real estate. These asset classes can be further divided into various sub-categories. How much should we allocate in each asset class? Or, which asset class should predominate our portfolio? Do we need to follow any thumb rule for asset allocation? All these questions hound us time and again while making financial decisions.

There is a popular misconception on asset allocation thumb rule that equity allocation percentile should be 100 i.e. based on the investor age. If an investor’s age is 60, the equity allocation in the portfolio should be 40% (100-60). However, it will not help the Investor in meeting his financial goals while inflation is zooming up.

How should one diversify assets in such a manner
that all financial goals are met?

The answer is that there is no straightforward way to allocate the assets. It varies according to the individual’s situation, depending upon the kind of assets that a person is holding, his financial goals, time-horizon and lots of other factors. There are few points which you can think upon and subsequently follow.

Financial Goal Tenure

Your investments must be aligned with your goals i.e. you should have goal-oriented investments. If the financial goal is short-term i.e. within 1-3 years, it is better to invest in bank fixed deposits or short-term debt funds where the principal amount is not subject to any market volatility. When the financial requirement is after 5 years or more, it is recommended to invest in equity related instruments.

For example, A 25 year old individual having 10 lakhs in his hand which he needs for his marriage in 3 years. As per Asset allocation thumb rule, he can very well invest in equities. But, since he needs the money for his marriage in three years which is short-term, no prudent financial advisor will recommend equity investment. On the other hand, if the same 25 year old individual has 10 lakhs which he needs at his retirement which is after 35 years, equity is the best option.

 Market Scenario & Economic Outlook

If the valuations of a particular asset especially equities are booming every day and markets are in euphoric stage with every stock moving upward, it is recommended to rebalance the profit to a certain extent and redirect the funds to the short-term debt funds. This action makes sense even if the objective of the respective investment is for the long term because you are protecting your profits and you can reinvest the same in equities in phased manner post the fall. This asset allocation strategy will work well within a particular asset class in the entire portfolio during the bubble phase of the markets.

For example, at the beginning of the financial year 2017, there was a constant discussion in the markets about rich valuations in both mid and small-cap segments. Investors who re balanced their allocation from mid and small-cap funds to Large-cap/multi-cap funds around that time participated in the peak cycle of mid and small-cap funds and also took added advantage of moving to Large-cap/multi-cap at attractive valuations. Not only this, they saved their portfolios from correction as mid and small-caps have corrected more than 15% in 2018 from their lifetime peak.

Goal-wise Asset Allocation

It helps if you allocate investments in your portfolio to a specific asset class as per the goal. Here are some real-life examples to understand it in a better manner.

• Early allocation to gold towards child’s marriage: Gold is considered as an auspicious metal associated with our culture, tradition, and not to forget our emotional attachment with this metal. If you look at it from asset allocation perspective, gold actually acts as an insurance to our portfolio. Hence, earlier allocation towards gold through Sovereign Gold bond, gold ETFs and gold funds towards childrens’ marriage goal will help in minimizing the risk of future price uncertainties and also meet the need of gold for this goal. But, exposure towards gold shouldn’t exceed 5-8% of the overall portfolio.
• Allocation to land estate for retirement: Many people move away from their hometowns during their work years in pursuit of better career opportunities. They wish to move back to their root at the advent of their retirement which is a sort of retirement goal for them. Early investment in real-estate/land in or around your hometown will help to meet the need for your own house during the retirement phase. But, this decision makes sense only if you have stable earnings to pay for the EMI’s for which you are taking the loan, and most important if the valuations are sensible and low. It is never a wise decision to buy real-estate at a premium just to fulfill one’s emotional desire.
• Allocation to international securities towards children foreign education: This might be helpful in minimizing the future currency risk. It will meet the need for this specific goal and will also reduce some operational difficulties during the goal occurrence.

 Risk Appetite & Psychological Factors

Each Individual is different, and so should be their asset allocation. Asset allocation should also specifically deal with the psychological behaviour of the investor as each investor behaves differently when it comes to volatility across various asset classes. If the real estate sector is down most people don’t feel bad due to the physical real aspect of the asset class. But if stock markets are down, a majority of investors panic as they see their valuations going down. Risk appetite is not the same for all individuals. Hence, all these factors need to be considered thoroughly before investing.