These two factors should determine your asset allocation
Investors tend to think that investing in asset classes that offer the best returns and timing the entry and exits at various points is the way to wealth. Sadly, this is completely flawed thinking and is the way most people destroy wealth and just scrape through life. In reality, getting the components of your portfolio right and allocating investments to the right assets is important for your success with finances. Right asset allocation is hence, at the heart of financial success. Ass et allocation is an art and a science.
The broad allocation can be arrived at based on various parameters. To that advisors need to apply the touchstone of their experience and wisdom and arrive at a portfolio recommendation, most suited to the individual or family. The advisor would need to factor in softer aspects like client's emotions and biases, their preferences and choices, their fears and inhibitions. Accounting for these and then arriving at the asset allocation, makes it an art as well as a science.
The two important parameters
The quantifiable parameters to first look at are risk tolerance of the person and the number of years to retirement. These two will determine how much of growth assets like equity one may have in the portfolio.
Equity assets and real estate are considered to be growth assets, which have the potential to offer returns well over the inflation rate. This is needed for the wealth to grow in real terms.
If one does not have too much time before retirement, then equity allocation will have to be low in the portfolio. How low it will be is a factor of one's risk tolerance. If one has a good number of years to retirement, then allocation to equity or real estate can be higher. Again, how much we allocate to these is a factor of one's risk tolerance. All portfolios will have a certain level of debt as a part of the strategic asset allocation. Debt gives stability to a portfolio and is needed in a portfolio.
Which instruments to choose?
The exact choice of instruments within equity and debt depends on many other factors like liquidity, tenure, income needs, taxation, credit quality and so on.
Now, within equity, an advisor will need to decide about which kinds of equity mutual funds they would want to recommend to the person they are advising. There are large-cap oriented MF schemes, mid-cap oriented schemes, multi-cap funds, hybrid equity fund,international funds, and so on.
Generally, one would recommend large-cap and hybrid funds as part of equity allocation for those who have a lower risk appetite or who have less number of years of working life. The more the investor's risk tolerance, the higher one can go as far as the riskiness in equity categories. For instance, a small-cap fund is way riskier than a large-cap or a hybrid equity fund. Hence, a small-cap fund can be offered for someone who has both high risk tolerance as well as a long working life.
Asset allocation at various stages in life Let us look at asset allocations of people at various stages in life. For someone who is 32 years old, earning well, will work till 60 years and with a high-risk tolerance level, the equity allocation can be between 70-75 percent. The allocations in equity can also be in midcap and even small-cap funds depending on these factors. Another person who is 45 years, having moderate risk appetite who is expected to retire at 58 and has good surplus every month can probably invest between 50-55 percent in equity assets. The equity investments for this person may be lower as the risk profile is moderate and the number of years to retirement is only 13 years.
Take yet another case of a person who is 55 and is set to retire at 60 years. This person has a moderate risk appetite and has good surpluses every month. The allocation in equity assets for this person can probably be between 45-48 percent.
For a person nearly at retirement, the typical equity allocation would be close to 40 percent. For retired people, we will allocate anywhere between 10 percent and 40 percent in equity, based on their risk tolerance levels, risk capacity, income needs and how much of their corpus can be locked in to equity given their upcoming goals in terms of travel, gifting and so on. Asset allocation over the life cycle Asset allocation will need to change over the years. risk-taking capacity itself slowly comes down over the years. One of the contributing factors is that capital preservation becomes much more important during the later years.
The other reason is that a person's risk tolerance itself slides over the years. Hence, one needs to lower the allocation to equity assets over the years and bring it to near about 40 percent, at around one's retirement. This is something that I'm personally comfortable with and advocate. Other advisors may have diifferent levels of growth asset allocations, which they advocate at various stages of life, including at retirement.
Risk capacity and tolerance
There is another aspect to consider called risk capacity of a person. The risk capacity is the potential that the person has to take risks. Let us take a few examples to illustrate this.
A person who is 30 years of age is said to have extremely good risk taking capacity as he has almost 30 years until retirement.This measure is quite different apart from the risk tolerance measure, which suggests the inherent risk bearing ability of a person. A person with a low risk tolerance level can well have high risk capacity. When risk capacity is high, one can push till the upper limits of the risk tolerance scale.
Another thing that affects the risk capacity of a person is the quantum of wealth. A wealthy person even at age 65 may have a high risk capacity. Such a person may be able to take risk due the wealth they have which gives a good cushion to any adverse effects of risk. Many times, wealthy people do take high levels of risk even at very advanced ages and this is due to their risk capacity.
There could be other reasons for risk capacity being high. Suppose a senior citizen has an inflation adjusted pension coming to him every month, the risk capacity of such a person would be very good. That is again because there is income certainty which allows him to take risks on the existing corpus.
The other reason could be that the spouse is working and is pulling in decent money. That could increase the risk capacity too.
Risk capacity will be high when risk does not affect a person as adversely as compared to most people, due to specific reasons. When there is high risk capacity, it allows one to push the limits of what is possible within one's risk tolerance levels. It is good to largely operate within the tolerance zones.
Risk required There is a third terminology called risk required. This is in the context of one's goals. To achieve certain goals, one may have to take on some amount of risk. When the risk required for achieving a certain goal is high, the right approach would be to either reassess whether the goal can be postponed. If that cannot be changed, one needs to see if the goal needs to be scaled down or more funds need to be allocated to this goal, while channelling funds from other goals to this. When the risk required is high, it may be good to truly reconsider the goal.Risk required will need to be subservient to risk tolerance and risk capacity. These are some of the risk measures which have a bearing on asset allocation, which advisors take into account while constructing and reviewing portfolios of clients.
Courtesy : Economic Times