The famous phrase in personal money management “Don’t put all your eggs in one basket” especially speaks about diversification of our wealth across various asset classes depending upon our own requirement, financial goals, risk appetite and various other factors. While diversification of assets ensures the mitigation of risk associated with each asset class, on the other hand, it also reduces the expected return from the respective asset class to a certain extent.
When wealth is concentrated within few asset classes, risk and return both are high. And, if wealth is diversified across various asset classes, it reduces both risk as well as return.
Usually, asset classes can be seen as equity, debt, gold, art, commodities, and real estate. These asset classes can be further divided into various sub-categories. How much should we allocate in each asset class? Or, which asset class should predominate our portfolio? Do we need to follow any thumb rule for asset allocation? All these questions hound us time and again while making financial decisions.
There is a popular misconception on asset allocation thumb rule that equity allocation percentile should be 100 i.e. based on the investor age. If an investor’s age is 60, the equity allocation in the portfolio should be 40% (100-60). However, it will not help the Investor in meeting his financial goals while inflation is zooming up.
The answer is that there is no straightforward way to allocate the assets. It varies according to the individual’s situation, depending upon the kind of assets that a person is holding, his financial goals, time-horizon and lots of other factors. There are few points which you can think upon and subsequently follow.
Your investments must be aligned with your goals i.e. you should have goal-oriented investments. If the financial goal is short-term i.e. within 1-3 years, it is better to invest in bank fixed deposits or short-term debt funds where the principal amount is not subject to any market volatility. When the financial requirement is after 5 years or more, it is recommended to invest in equity related instruments.
For example, A 25 year old individual having 10 lakhs in his hand which he needs for his marriage in 3 years. As per Asset allocation thumb rule, he can very well invest in equities. But, since he needs the money for his marriage in three years which is short-term, no prudent financial advisor will recommend equity investment. On the other hand, if the same 25 year old individual has 10 lakhs which he needs at his retirement which is after 35 years, equity is the best option.
If the valuations of a particular asset especially equities are booming every day and markets are in euphoric stage with every stock moving upward, it is recommended to rebalance the profit to a certain extent and redirect the funds to the short-term debt funds. This action makes sense even if the objective of the respective investment is for the long term because you are protecting your profits and you can reinvest the same in equities in phased manner post the fall. This asset allocation strategy will work well within a particular asset class in the entire portfolio during the bubble phase of the markets.
For example, at the beginning of the financial year 2017, there was a constant discussion in the markets about rich valuations in both mid and small-cap segments. Investors who re balanced their allocation from mid and small-cap funds to Large-cap/multi-cap funds around that time participated in the peak cycle of mid and small-cap funds and also took added advantage of moving to Large-cap/multi-cap at attractive valuations. Not only this, they saved their portfolios from correction as mid and small-caps have corrected more than 15% in 2018 from their lifetime peak.
It helps if you allocate investments in your portfolio to a specific asset class as per the goal. Here are some real-life examples to understand it in a better manner.
Each Individual is different, and so should be their asset allocation. Asset allocation should also specifically deal with the psychological behaviour of the investor as each investor behaves differently when it comes to volatility across various asset classes. If the real estate sector is down most people don’t feel bad due to the physical real aspect of the asset class. But if stock markets are down, a majority of investors panic as they see their valuations going down. Risk appetite is not the same for all individuals. Hence, all these factors need to be considered thoroughly before investing.
There is no defined rule when it comes to asset allocation. It varies depending upon each person’s individual and financial requirement, psychological behaviour, risk appetite as well as the prevailing market scenario.