What Is Asset Allocation And How To Manage It?
This is one of the most common & popular concepts in personal finance. I also find that it is very often complicated far more than it needs to be.
In this post, I will try to layout the very basics of Asset Allocation.
Going to first principles:
Asset allocation is about minimising your risk of losing capital.
That is it!
Everything else beyond that should still tie back to this basic principle.
The next most important thing is your risk appetite.
If you have a higher risk appetite you will invest in assets that are more volatile ex. Equities.
A lower risk appetite means you stick to more Safe instruments such as a fixed deposit or real estate.
What Assets are we talking about here?
Let’s list some of the most common assets
Lower risk:
- Fixed Deposit
- Real Estate
- Debt Funds
- Gold
Higher risk:
- Equities
- Alternative Investments such as venture funds.
- You can also add cryptos and NFTs to this list
Returns are typically proportional to risk. The same list above works for lower returns & potentially higher returns as well.
The most important aspect for you is to understand at what level of risk you will get a good nights sleep.
Are there any standard methods of asset allocation?
There are a few. The most popular one is to do with age.
Start with the number 100.
Subtract your age from 100.
The number left is the % you should invest in equity.
Ex. for a 30-year-old person, 70% of the investments should be in equity.
However; this is a very traditional way of thinking. The idea is to reduce your equity exposure as you age.
This assumes a retirement age of around 65. For someone who wants to retire early this kind of thumb rule would not work.
The other issue is that the equity allocation keeps reducing with age. Whereas I would look at it being an inverted bell shape. As you get older there will be a point where your risk appetite can go up again.
What other approaches are there ?
Here is how I think about it.
There are a couple of thumb rules I like to use.
Rule 1. Peace of mind is important.
So don’t leverage or invest in something which will give you sleepless nights. Only you know where your threshold is.
For some, a notional loss of 25 lacs may not impact their peace of mind. Whereas for others a 2 lac drop in notional value might make a big impact.
Rule 2. Always have some money ready to invest when the market provides an opportunity.
To do this your need to have some money set aside in debt funds. Usually, debt funds don’t get impacted when the equity markets drop. So you can use this money to invest in equity whenever the market provides an opportunity.
That should be it. Within that guidance, you can create your own asset allocation plan. Keep in mind that equities grow faster but can also go down. Asset allocation is always about being ‘safety first’. You can then figure what works for you and work out the appropriate asset allocation.
What about Real Estate and Gold?
Both of these are very popular asset classes with us Indians.
Gold
Over the last many years Gold has given good returns in India.
But if you peg it to the $ then there has hardly been any meaningful return.
Gold price has gone up as the price of the $ has gone up.
Gold is supposed to be an asset that helps you hedge against inflation. To that extent, you can make it part of your portfolio if you are keen.
Please read this article on investing in Gold
Real Estate
Real Estate had a fantastic run in the early 2000s in India. It has not seen that kind of return since about 2012 or so. However, there are always very strong opinions on both sides of the real estate fence.
My personal opinion is that it is very illiquid. Therefore it does not make sense to make real estate a large part of your portfolio.
Especially if you can get the same kind of hedge through other assets. You can also invest in REITs to make up the real estate component of your portfolio. In my book real estate is firmly part of your debt allocation.
Finally, you still want your portfolio to have good returns while minimizing risk. Keep equity to the maximum of your risk appetite as that is still the best return on investment.
Within Equity there are ways to minimise your risk, one of these is to stick to investing in the Index.
My own ideal asset allocation plan is as below:
- Equity: 60%
- Debt Funds (includes EPF, PPF) : 20%
- Real Estate: 15%
- Gold: 5%
My current actual asset allocation is a little off:
- Equity: 46%
- Debt Funds (includes EPF, PPF) : 13%
- Real Estate: 37%
- Gold: 4%
The Real estate component is because of previous investments. This was before I started my journey in personal finance.
As you can see, I still have a way to go to get to my ideal asset allocation.
My focus is to keep growing the equity portion of my portfolio till it gets to the ideal point.
How often should one balance the asset allocation:
Some advisors advocate an annual rebalance. I think as long as you are aware of where your actual asset allocation is compared to your ideal that is good enough. Keep working on the parts of your asset allocation you need to shore up.
A general caveat: selling one asset class to balance the allocation is usually tax-inefficient. If you have the ability to invest more, then use the additional investments to balance.
Key Takeaways:
- Asset allocation is a very important part of your personal finance planning.
- You can keep it simple or end up complicating it endlessly
- At a basic level it is about minimizing the risk of losing capital
- It then boils down to your individual risk appetite –
- what level of risk will give you a good night’s sleep
- You can use low risk and low return assets like:
- Fixed Deposits,
- Debt Funds,
- Real Estate and
- Gold
- Use these to shore up your portfolio against the volatility of equities.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.
