You should have a strategic asset allocation mix that assumes that you don’t know what the future is going to hold.
-Ray Dalio (American billionaire, hedge fund manager, philanthropist)
The one thing I have learned since starting on this Personal Finance journey is the fact that no one can predict the future, be it in interest rates or market performance. With that knowledge, as Ray Dalio says in the quote above, it becomes imperative to follow an asset allocation like a route map. This complete guide will resolve all your queries about asset allocation.
What is asset allocation?
Investopedia defines asset allocation as – Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon.
This definition is quite a handful and it makes sense to break it down. As pointed out, it is an investment strategy that helps in dividing your investment funds into various classes. The 3 factors that determine your asset allocation are:
As mentioned earlier, goal-based investing gives a far better idea of our destination and reason for investing. Your goal also determines the other two factors of risk tolerance and investment horizon.
Once you know your goal, you have a clear idea about the time horizon for which you can invest. So, if your child is 8 years old today and you know your need for his education expenses at 18, your time horizon is ten years
This has a lot to do with time horizon and even back up funding for the goal. With a longer time horizon, like 20 years to retirement, higher risk can be easily tolerated. As for the goal, suppose along with your investment for retirement, you are also eligible for a pension that you are looking at as bonus money and not accounting in your calculation for the retirement corpus, your risk tolerance would again be higher as your dependence on the corpus and it’s performance gets lowered.
Levels of asset allocation
There are various levels of allocation that you can look at. For most purposes, asset allocation is restricted to the asset classes of debt, equity and gold. In most cases, real estate just ends up toppling the asset allocation balance unfavorably, hiding any picture it could provide. If the assets in the other classes increase in the amount to reach the real asset levels, then you could look at including real estate in your asset allocation mix. Debt refers to investing done through bonds or debt mutual funds whereas investment is gold today is mostly done through gold funds or ETFs rather than holding on to the metal.
First level of asset allocation
In the first level, you would need to decide your bifurcation of funds into the main asset classes like debt, equity and gold. One of the most widely recommended asset allocations is 10% gold, 20% debt and 70% equity. However, considering the shoddy performance of Gold ETFs in India in the recent past, you could consider dividing your allocation just among debt and equity.
Another rule of thumb is to invest in equity as a percentage of 100 – your age. So, if you are 32, this rule tells you to invest 68% of your portfolio in equity with the remaining in debt. Since one size does not fit all and your age cannot be a real determinant of asset allocation, I am not much of a fan of this rule.
Ideally, fix an asset allocation for all your goals separately as they will follow a path of their own. For instance, when you are about 1 or 2 years away from needing the funds for your child’s education, it is ideal to put them in risk-free instruments to avoid them from the uncertainty of markets.
Second level of asset allocation
Within the major asset classes also, there is a decision to be made as to what kind of allocation will be made. For instance, if you are investing in equity, what proportion of the funds will be devoted to the stable option of mutual funds, and how much time and funds are you willing to devote to stock picking.
Third level of allocation
Even after a decision of how much to invest between direct stocks and mutual funds, you might want to tune it down further to decide the allocation between the different type of equity classes – large, mid and small cap.
Geographical asset allocation
Another way of allocating assets is to diversify by geography by investing some assets in foreign lands. However, that should be done only at an advanced level as the home advantage means you will be far more aware of your own market than any other.
Why is asset allocation important?
If you are thinking that this is too much work, then read on to know the merits and the importance of following an asset allocation policy in your portfolio.
As they say – do not put all your eggs in one basket. Ensure that your portfolio has inversely moving asset classes. By that I mean, asset classes like debt and equity generally follow opposite directions of movements – when one rises, the other falls and vice versa. This diversification is key to safeguarding your losses and achieving relatively okay results even in a bear market.
Sure, you can turn around and say that diversification brings down returns in a bull market. That’s why we started with the Ray Dalio quote – you need an asset allocation mix because it protects you from the unpredictability of the markets. Almost like an insurance policy for your investing.
In most cases, risk and return are directly proportional, requiring an investor to take higher risk for a higher potential return. Asset allocation plays on this trade off by moderating both – the risk and resultantly the return and brings them down to a level that you can sleep peacefully with the knowledge of.
It puts goals at the centre of the equation
We all earn, save and invest money as a means of fuelling our financial dreams and goals. With asset allocation, we are putting those goals at the centre and as the main objective rather than a “who can get a higher return” contest with hard earned investing money.
Asset allocation ensures that you need to make only minor tweaks or look at portfolio rebalancing only once in a while. It is pretty much a lock it and forget it portfolio management practice where checks and rebalancing possibility even once a year are good enough (unless you are investing in stocks where once a quarter or maximum once a month is preferable).
Reduces dependence on individual picks
While asset allocation is a widely accepted norm, Roger Ibbotson presented a contrarian view by doing some research to show individual picks were a more important input to the result rather than asset allocation. However, not all retail investors have the luxury of the time, effort and knowledge that right stock or fund picking and monitoring require. Asset allocation thus neutralises the variability that individual picks can bring in to your portfolio.
Asset allocation remains key to getting this right balance in your investing. What do you think? What is the asset mix that you follow in your portfolio? Let me know in the comments.