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5 points to remember about asset allocation

Apr 30, 2022 / Dwaipayan Bose | 16 Downloaded | 1274 Viewed | |
Picture courtesy - Freepik

There is growing awareness about asset allocation among financial advisors and experienced investors in India. The unexpected fallout of COVID-19 outbreak and the market crash in 2020 reinforced the importance of asset allocation to many investors. Financial advisors have been asking their clients to invest according to an asset allocation plan. Asset allocation is of utmost importance to navigate through volatility and uncertainty in wake of the War in Ukraine and high commodity prices.

What is asset allocation?

Asset allocation is spreading your investments over different asset classes e.g. equity, fixed income, gold etc. The main purpose of asset allocation is to balance risk and returns. If you are over-invested in one particular asset class, you may end up either taking too much risk or get sub-optimal returns.

Suggested reading: What is asset allocation and why it is important

In this article we will discuss five points that you should always remember planning and managing your asset allocation.

1. Change your asset allocation with age / life-stage

You should have a target asset allocation which should change with age / stage of life. For example, if you are 30 years old and investing for retirement, you should have higher allocations to equity because you have plenty of time to ride out the market downturns. Historical data shows that equity as an asset class, can give higher returns over long investment horizons compared to other asset classes.

As you get closer to retirement or other life-stage goals (e.g. children’s higher education, children’s marriage etc.), you should have higher allocations to fixed income which provides more stability to your portfolio for your financial goals. After retirement, when you are dependent on the income from your investments, a large part of your asset allocation should be in fixed income which generate income for you. However, you should not ignore equities completely because your expenses will keep increasing due to inflation. Historical data shows that equity can give inflation adjusted returns in the long term.

The Rule of 100 – Age, is a popular asset allocation rule of thumb. According to this rule, 100 minus your age, should your asset allocation is equity. For example, if you are 40 years old, your equity allocation should be 60% and fixed income allocation should be 40%. Though you do not have to strictly follow this rule, it can serve as a useful guideline when you think about your asset allocation.

2. Your risk tolerance is important in your asset allocation

You should understand the difference between risk capacity and risk tolerance. Risk capacity refers to your capacity of taking risk depending on your age, stage of life, sources of income, assets, liabilities etc. Risk tolerance on the other hand, is more of a personality trait on how you may react to adverse situations. An individual with high risk capacity may not necessarily have high risk tolerance. Your risk appetite in investments should be a combination of both your risk capacity and risk tolerance.

If you ignore your risk tolerance completely you may end harming your financial interests in the long term. For example, if you have high risk capacity (e.g. young investorwith relatively low liabilities) but low risk tolerance and are heavily invested in equities, you may sell your investments when the market crashes. This will be harmful for your financial interests. Risk tolerance often increases with experience. If you are new investor, you can invest in large cap funds or balanced advantage funds, even though you may have higher risk capacities according to your age.

3. Diversify your portfolio within different asset classes

Within each asset class, there are different sub-categories with different risk profiles. You should diversify your portfolio across different types of investments within asset classes:-

  • Equity categories: Within equity, we have large cap (top 100 stocks by market capitalization), midcap (101st to 250th stocks by market capitalization) and small cap (251st and smaller stocks by market capitalization). Different market cap segments have different risk profiles. Diversify your equity portfolio across 2 or more market cap segments according to your risk appetite.

    You may like to read: how much mid and small cap allocations you should have in your portfolio

  • Fixed income categories: Within fixed income we have funds investing in debt and money market instruments with maturities ranging from 1 day to 365 days (e.g. overnight funds, liquid fund, ultra-short duration funds, low duration funds etc.). These are suitable for investment tenures of less than 1 year. For short to medium investment tenures (1 to 3 years) short duration, corporate bond funds, banking and PSU bond funds etc. can be suitable investment options. For long investment tenures (3 years or more) long duration funds, dynamic bond funds, Gilt funds etc. can be suitable investment options. Invest according to your different financial goals and risk appetite.

  • Other asset classes: Gold and real estate are the other two popular asset classes in India. Investors usually prefer to invest in the physical forms of these asset classes e.g. gold jewellery, residential / commercial property etc. Investing in Gold ETFs is much more cost efficient (e.g. low storage cost, no impurities etc.) compared to investing in physical gold. You can also invest in real estate as a financial asset in the form of REITs. Several mutual funds like multi asset allocation funds invest in Gold and REITs. Among precious metals, one can also invest in silver in financial form through Silver ETFs. You should invest in these asset classes according to your risk appetite and financial goals.

    Related read: How to choose the right mutual funds according to your need

4. Remain disciplined in your asset allocation

Having an asset allocation plan is important for achieving your financial goals. Your asset allocation plan should depend on your risk appetite and investment needs. You should not change your asset allocation simply because market conditions at a point of time may be favouring a specific asset class. For example, many investors keep buying equities in bull markets ignoring their asset allocation plan because NAVs of equity funds keep increasing. Such investors have to face a bigger loss when the market corrects. Remain disciplined in your asset allocation irrespective of market conditions. Remember market conditions will change in the future, but your financial goals will not.

Related read: How can you maximize your mutual fund SIP returns?

Rebalance your asset allocation at regular intervals

Some asset classes in your investment portfolio will grow faster or slower than other asset classes in different market cycles. Therefore, over a period of time the asset allocation of your investment portfolio will deviate from your target asset allocation or asset allocation plan.

For example, in the last 2 years (ending 31st March 2022), Nifty 50 TRI gave 116% absolute returns (47% CAGR returns), while the Nifty 10 year benchmark G-Sec Index (as a proxy for fixed income) gave just 4% returns. If you have not rebalanced your asset allocation, your portfolio asset allocation will be much more skewed towards equity than what your target asset allocation should be according to your risk appetite. This can be a problem, especially if you are approaching your financial goals. You should rebalance your asset allocation at regular intervals. Rebalancing will reduce downside risks, provide portfolio stability and also help you get risk adjusted returns.

Conclusion

In this blog post, we discussed 5 points you should always consider when planning and managing your asset allocation. Through proper asset allocation planning you can take optimal risks to get the right returns needed for your financial goals. You should consult with your financial advisor if you need help in understanding your risk appetite and planning your asset allocation.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.

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