Recently, one of my blog readers posed an important question. He inquired that – I’m 25 years old and don’t have any major goals as of now. Can my asset allocation be 100% in equity as per my age? Upon asking him whether he was a salaried employee or businessperson, I found out that he was a salaried employee.
I answered, anyways, that you cannot have 100% asset allocation in equity. The reason is that you must be contributing some amount towards your PF if you’re working in the private sector. And to create an emergency fund, you need to invest in debt instruments only.
My second question to him was that – Who suggested you to have 100% asset allocation in equity?
He replied that everyone he had spoken to advised him to invest in equity for the fulfillment of long-term goals.
Here comes the 3rd question from my side – You just told me that you do not have any major goals, right?
No, I want to retire at the age of 45 and equity offers better returns in the long-term. He said.
Yes, most of the experts in Media suggest investing in equity for the long-term. But what they don’t tell you is that there should also be a debt portion associated with it.
Let me take an example for better understanding. You, at the age of 25, invested all your funds in equity. Recession comes in after another 2 years. Obviously, the market will fluctuate and go down. As a consequence, your portfolio will be deep in the red.
What would you do if you happened to lose your job at the same time? There would be no other option left except to withdraw the money from equity and take a solid loss. Would you ever invest in equity again? The chances are very less.
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What is Asset Allocation ?
Asset is allocation is dividing your investments in different assets class like stocks, mutual funds, gold, real estate, FD and bank savings etc. as per your risk profile, time frame and goals.
Asset Allocation Example
Let’s take another example of asset allocation. There was a person who heard that – Nifty has hit an all-time high, and mid-caps have fallen by 50%. It’s the right time to invest in equity.
As a result, the person invested half of his portfolio in mid-caps. After a month, the portfolio was down by another 25%. He did that because there was some deficit appearing in his retirement corpus as per the calculations.
He tried to fill in the gap by making an investment in mid-caps. His retirement was just 3 years away. What could he do now? The only option that was left was to wait and watch. Moreover, the deficit in his monthly retirement expenses was only 3000/4000.
Now, the people who are extremely conservative in their approach will never talk about asset allocation. The only time they consider it is when there is an urgency of money.
Having said that, let me give you one more example of asset allocation to help you form a better perspective.
There was a 47-year old guy who owned 7 real estate properties. He hardly had any liquid investments. Out of these 7, he had purchased 2 in the last 2 years only. Now, his daughter`s educational goal had to be fulfilled in the coming year. Since he did not have any liquid investments; the only option left was to sell the real estate he owned. Believe me, it took him around a year to sell one of the properties and that too with a loss.
There are numerous examples which I can give to improve your understanding. Yet, it would still be difficult to arrive at an all-in-one solution for asset allocation. Anyways, I’ll try my level best.
Assets Allocation Strategies
First and foremost, you should never decide your asset allocation strategy on the basis of your age. Before arriving at an asset allocation strategy, you should decide your goals first.
Suppose you are 25 years old and earning quite well. You want to purchase a car in the next 3 years. Hence, you are accumulating a specified amount for making the down payment of the car. Should you invest in equity mutual funds or stocks for the fulfillment of this goal? No, the investment should be made in debt instruments.
Now, suppose you want to purchase the same car after a 7-year period. For that, you can go for a ratio of 50:50 in equity and debt mutual funds.
Whether you are 25/35/45 or 55 years old, how does it even matter?
Once you have defined your goals, you should examine your risk appetite. Furthermore, there are 3 types of investors – ABC
A – Aggressive
B – Balanced
C – Conservative
But why is it important to define your risk appetite? Suppose you are a conservative investor who has been investing in equity for the last 3 years. The only reason for doing so is because you heard that equity gives higher returns than debt instruments. Nonetheless, the returns in equity are only 1%, the chances that you’ll shift again to debt instruments are very high. The chances are that you will never come back to equity because of the risk and no guarantee of returns. You will undoubtedly shift back to FDs/PPF as these financial instruments offer fixed returns year after year.
So, if you are a conservative investor, your long-term period should be longer than a balanced and aggressive investor.
Similarly, an aggressive investor would always be biased towards equity investments. The reason is that he/she knows that the returns can be 4-5% higher than debt instruments in the long-term.
Control your emotions, this is one of the most essential life skills that no one can teach you. People tend to become high-risk takers when the markets are moving in an upward direction. The same set of people will turn into low-risk takers when the markets start going down. Even a 5% correction will make such people think whether they have done the right thing by investing in equity.
Now let’s try to define goals one by one and discuss how your asset allocation strategy should be laid out.
Child Education Goal
- Suppose you are a newly married couple who’s planning to have a kid in the near future. In this case, you can definitely invest 100% in equity for the fulfillment of your child’s educational goal.
- Suppose you are having a child whose education goal is just 10 years away. In this case, you can invest in equity/debt instruments in the ratio of 50:50.
- Whereas if the child education goal is just 5 years away, it’s preferable to invest only in debt instruments.
Child educational goal is indeed a very emotional one, at least for most of the Indian parents. So even if you are an aggressive investor who only believes in equity investments, it still doesn’t matter. You should keep everything in debt when the goal is just 5 years away. Because if you don’t have money at the right time, you may be putting your child`s life at stake. And if you try to compensate for the same from your retirement corpus, you’d put your retirement life at stake. So, the choice is yours.
Child Marriage Goal
For this particular goal, you can avail the liberty of investing a higher amount in equity. But in India, the story is somewhat different. Here, people tend to accumulate more for their children’s marriage than education. If your social reputation is not significantly impacted by the same, here is a small asset allocation strategy for you.
- If your child’s marriage goal is 20-25 years away, you can invest 100% in equity.
- Even if it’s between 12-15 years away, you can have an asset allocation of 80:20 in equity and debt.
- If it is around 10 years away, you can have an asset allocation of 70:30. But then you must keep reducing the equity component by 10% every year. And by the time the goal is just 3 years away, you should keep everything in debt.
First of all, check how much percentage of PF/NPS is there in your asset allocation. I consider both as debt instruments (though NPS is considered an equity component). Also, examine the percentage of other debt instruments in your portfolio. After that, check your risk appetite.
- Suppose your goal is 25 years away. In this case, you can have an equity/debt ratio of 70:30 provided that you are a balanced investor. If you are an aggressive investor, you can go for 80:20 as well. Whereas if you are a conservative investor, choose 60:40.
- Suppose your goal is 15 years away. In this case, you can have an equity/debt ratio of 60:40 provided that you are a balanced investor. If you are an aggressive investor, you can go for 70:30 as well. Whereas if you are a conservative investor, choose 50:50.
- When your goal is just 10 years away, you can have an equity/debt ratio of 40:60. For that, you must be a balanced investor. If you are an aggressive investor, you can go for 50:50 as well. Whereas if you are a conservative investor, choose 30:70.
- Commence reducing your equity ratio by 10% every year when the goal is just 10 years away. The aggressive investor can retain 30% at the time of retirement. The balanced and conservative investor can keep 20% and 10% in equity respectively.
There is a very simple logic that has to be followed for other remaining goals.
Keep investing in recurring deposits.
Overseas Vacation After 3 years
Start investing in debt mutual funds.
If the goal is anywhere within the range of 5 years, you should invest in debt funds. For a 10-year period, invest in the ratio of 70:30, 60:40 or 50:50 as per your risk profile. If your goal is 15-20 years away, you can opt for higher equity investments.
This was my take on asset allocation strategies. You are most welcome to share your valuable opinions.
Till Then, Happy Investing!