Today, we look at how to determine the right asset allocation.​​

Some points to bear in mind:

 

• Your ideal asset allocation is the mix of investments, from most aggressive to safest, that will earn the total return over time that you need.
• The mix includes stocks, bonds, and cash or money market securities.
• The percentage of your portfolio you devote to each depends on your time frame and your tolerance for risk.
• This isn’t a one-time decision. Revisit your choices from time to time to see if it is still meeting your needs and goals.

Minimize Risk, Maximize Return​

The goal of allocating your assets is to minimize risk while meeting the level of return you expect. 

To achieve that goal, you need to know the risk-return​ characteristics of the various asset classes. 

​Some of the key factors used to determine the right asset allocation are:

1. Age 

A commonly cited rule of thumb to simplify equity allocation is that an individual should hold a percentage of equity equal to 100 minus their age. For example, for a typical 30-year-old, 60% of their portfolio should be equities and the rest would comprise of debt, gold, etc.​

The principle of investing at play here is to gradually reduce risk as an individual get older. 

Young individuals have higher risk-taking ability and can allocate a bigger chunk of their portfolio to equities. 

Older individuals, on the other hand, require a steady stream of cash flows and often find it difficult to deal with volatility, hence should have minimal exposure to equities.

If you are bullish on the economy, then you can use this metric to identify your allocation to equities. 

However, if you possess knowledge about investing and are aware, then you can decide your asset allocation as per your own discretion. 

2. Time Horizon

Time Horizon is linked to the above factor and plays a crucial role in determining asset allocation. 

To achieve short term goals, fixed income securities like fixed deposit, liquid funds, ultra short term funds, and low duration funds should be used. 

On the other hand, for long term goals, equity is the ideal asset class.

Individuals should not invest in equity to meet their short-term goals, as it would be pure speculation. 

Individuals should exercise caution at all times to avoid making such mistakes.

3. Financial Goals

One should have clarity about their financial goals. They should know the amount of funds required and the time in hand to meet those financial goals. 

Only when individual is cognizant about this can they move forward and choose the right asset class.

4. Number of dependents

If an individual has more people dependent on them, there would be relatively more short term goals such as medical expenses for old parents, high educational expenses for children, etc. 

In such a scenario, an individual should possess sufficient liquidity to meet financial goals at the right time, and therefore, they should meticulously plan their asset allocations accordingly, well in advance.  

5. Risk Profile

Risk profile is an evaluation of an individual’s willingness and ability to take risks. 

It is subjective in nature and differs from one person to another. It deals with an individual’s behaviour. 

A risk profile is important for determining a proper investment asset allocation for a portfolio.

Risk profiles can be divided into conservative, moderate and aggressive. Individuals should identify their risk profile and make investment decisions taking that into consideration.

At times, a person may have the willingness and financial ability to take more risk, but lack the risk-taking capability and cannot handle volatility. They may lean more towards a conservative approach and should therefore have more debt allocation and less equity allocation.

6. Income Stability

The pandemic has opened our eyes to the fact that income stability is the most important of all factors. Job security, employment status, and regularity of cash flow matter while deciding asset allocation.

Businessmen might face irregularity in cash flows and should have abundant liquid funds and investments in debt to meet short term goals. 

On the contrary, if one has a job and enjoys the luxury of a constant stream of cash-flow, they can increase allocation to equities based on their financial goals.