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Session 7: Ideal Asset Allocation

We are glad to have you with us for our Seventh Session - Ideal Asset Allocation

Alright so now let's get started.

All of us have some goals in mind such as buying a dream home, a car, travelling abroad for leisure, children's education, their marriage and even our own retirement needs. And to achieve them, we all endeavour to create wealth by investing in various assets classes as per our risk taking capability.

Some of us are conservative and want to invest only in fixed income instruments because of the fear of losing money, while some of us are aggressive and want to invest in risky asset classes to generate higher returns. But here it is vital to recognise that all asset classes do not move in the same direction at the same time. Therefore it becomes imperative for us to diversify our investments across various asset classes and invest according to our asset allocation.

So first let us understand, what is meant by Asset Allocation.

What is Asset Allocation?
But the next question that arises is - How is Asset Allocation Determined?

So let us take a look at some key parameters that you should use while determining your asset allocation...

Parameters to Determine Asset Allocation

Asset Allocation can be determined on the basis of following factors:
  • Age
  • Income
  • Expenses
  • Assets
  • Liabilities
  • Time Horizon
  • Willingness to take Risk

Let's take up each of them in more detail.

  • Your age is one of the biggest factors in determining your asset allocation (...When you are young you can take higher risk and invest into riskier assets such as equity.)

  • As your age increases your risk taking capability decreases (...and you become risk averse)

Age Risk Taking Capability
25 High
55 Low

The table here shows that an individual who is of the age of 25 years has much higher risk taking capability than an individual whose age is 55 years. It happens because an individual at the age of 25 years has more time to recover from bad phase of riskier assets and therefore can afford to take higher risk. So if you have not yet started defining your asset allocation, then you should start immediately!

  • Your income also determines your asset allocation

  • High income = high risk tolerance (...An individual who has high income and high expected growth rate in the future, can tolerate higher risks. He can invest more in riskier assets.)

Growth Rate in Income p.a. Risk Taking Capability
25% High
0% Low
(This table is indicative, and for illustration purpose only)

In the table you can see that if you have an expected growth rate in your expenses as low as 5% as compared to an individual who has 20% expected growth rate, then your risk taking capability is much higher than the other individual.

  • The existing assets you hold in your investment portfolio is vital while determining your future asset allocation

  • Consider the concentration level of each asset in your portfolio (...Some individuals are too heavily invested in a particular asset class and forget to diversify their investments. Some believe that real estate is the best asset class to invest in as it gives them dual benefit of appreciation in value of the asset as well as rental income. But what they forget is, real estate is also an illiquid asset class which cannot be sold easily in case of emergencies.)

  • (...You should) Never put all your eggs in one basket (...So proper asset allocation is necessary to diversify your investment portfolio well.)

  • Consider your loans and liabilities while determining your asset allocation (...You see, your current liabilities can also affect your asset allocation. If you have big liabilities, then you have a huge burden to service them and that decreases your investible surplus and also your risk taking ability.)

  • High interest rate on your loans leads to burden on your cash flows (...So, in case you owe a lot, then you need to invest in low risk asset class such as debt, because any increase in interest rate on your loans taken can affect your cash flows negatively.)

Liabilities Risk Taking Capability
Less High
More Low
(This table is indicative, and for illustration purpose only)

The table here shows that the lesser your liabilities, the more risk you can afford to take and vice-versa.

Time Horizon
  • Consider your investment time horizon (...Asset Allocation is also determined on the basis of Time horizon in which you wish to accumulate an amount for your future goal.)

  • Longer time horizon = High risk taking ability (...Longer your time horizon higher the amount of risk you can afford to take.)

Time Horizon (Years) Risk Taking Capability
30 High
5 Low
(This table is indicative, and for illustration purpose only)

In the table you can see that when you have a time horizon of 30 years, you have a much higher risk taking capability, than if you have just 5 years of time horizon. Longer time horizon leads to increased risk taking capability and higher allocation towards riskier assets classes.

Willingness to take Risk

Your willingness to take risk determines what amount of return you should expect from your investments.
  • Are you ready to take high risk? (...While investing ask yourself, are you willing to take high risk? If the answer is yes, you can look to have high allocation towards high return generating instrument like equity. If the answer is no, then you should identify and allocate assets for your portfolio prudently.)

  • High Risk = High Return (...Do not forget, you may get rewarded for taking high risk, but there may be risk on your capital invested.)

  • Low Risk = Low Return (...If you are not willing to take risk, you will have to compromise on your returns as well.)

Asset Class Risk Return
Equity High High
Real Estate    
Debt Low Low
(This table is indicative, and for illustration purpose only)

In the table you can clearly see that Equities have the highest return expectation but also carry with them the highest risk. Debt on the other hand, offers the lowest return expectation and thus the lowest risk.

So if you are willing to tolerate higher risk involved in Equities, then your allocation towards Equities will be higher and you can also expect to earn higher return over the long term. But if you cannot tolerate higher risk, then you would be better-off allocating a higher percentage towards debt, but at the same time it will also decrease your return expectation.

You see, it is vital to define your risk tolerance first and then determine which asset class you should be investing in.

How to determine an asset allocation?

(A Case Study...)

To help you better understand how an asset allocation is determined; let's take an example of 3 individuals who are at different stages of their life cycle.

Name Vijay Ajay Sanjay
Age 30 45 60
Life Stage Unmarried Married with 2 Kids Retired
Income Medium High Low
Expenses Medium High Low
Assets Low Medium High
Liabilities Medium High Low
Time Horizon High Medium Low
Willingness towards Risk High Low Medium
Overall Risk Appetite High Medium Low
(This above table is indicative and used for illustration purpose only.
The names used in the table are fictitious)

Vijay is a 30 year old unmarried individual, while Ajay is a 45 year old married person with 2 kids and Sanjay is a 60 year old retired individual.

Since Vijay is young and has just started earning a few years back, he has only a few assets but his time horizon is around 20-30 years, so his overall risk taking capability is high.

Ajay's income is high, but he also has dependents and liabilities. His time horizon is 10-15 years, so his overall risk taking capability is moderate.

Sanjay is retired and only his spouse is dependent on him. Since he does not have any income, he relies on his assets to take care of his day to day expenses. His time horizon is short and therefore his overall risk taking capability is low.

So what could be a suitable asset allocation for each of them...

Ideal Asset Allocation for Vijay
Asset Class Allocation (%)
Equity 80%
Debt 15%
Gold 5%
(This table is indicative, and for illustration purpose only)

Well, in case of Vijay since his overall risk taking capability is high and he has a long term time horizon, his allocation towards Equity should be the highest and lowest towards Debt. So he can invest around 80% of his investible surplus in Equity, 15% in Debt and 5% in Gold. This allocation is expected to give him high returns, but at the same time, he will have an aggressive investment portfolio. He need not be too much worried about it though, as his time horizon is long term and his investment portfolio has a lot more time to recover from the short term down turn in the equity market.

Ideal Asset Allocation for Ajay
Asset Class Allocation (%)
Equity 65%
Debt 25%
Gold 10%
(This table is indicative, and for illustration purpose only)

In case of Ajay since his overall risk taking capability is moderate and he has medium term time horizon, he can have a mix of equity and debt with slightly higher allocation towards equity. So he could invest about 65% of his investible surplus in Equity, 25% in Debt and 10% in Gold. This allocation is expected to give him sufficient returns to achieve his future goals, with a balanced investment portfolio.

Ideal Asset Allocation for Sanjay
Asset Class Allocation (%)
Equity 20%
Debt 75%
Gold 5%
(This table is indicative, and for illustration purpose only)

In case of Sanjay since his overall risk taking capability is low and he has a short term time horizon, he needs preservation of capital. So Sanjay should have high allocation towards Debt, slight allocation towards Equity and lowest towards Gold. So he can invest around 20% of his investible surplus in Equity, 75% in Debt and 5% in Gold. This allocation will give him low returns from a low risk investment portfolio.

This portfolio would be ideal for him as his main objective is preservation of capital rather than growth on investments, since he is not earning and dependent upon his portfolio for his day to day expenses.)

So far we have learned what asset allocation is and how ideally determining it will benefit you to diversify your investment portfolio. But before we wrap-up this session of learning, here are some points you must keep in mind while managing your finances.

Points to Remember
  • Invest early (...As we have learnt in our earlier learning session, it is the early bird who gets a bigger pie. Also, as your age increases your risk taking ability reduces. So start your investments early, so that you can take the benefit of a long term time horizon and possibly even be skewed toward equity for better wealth creation.)

  • (Remember if you ...) Have higher future growth in Income, it increases your risk taking ability

  • Keep a track of your expenses (...Avoid any unnecessary expenses; because a penny saved is penny earned)

  • Diversify your assets (...You should not be biased towards any particular asset class. Try to diversify your investments to reduce the overall investment risk on your portfolio.)

  • Avoid excessive loans (...They can disturb your asset allocation pattern. So ensure that you are not taking too much burden of managing excessive loans.)

  • Longer your time horizon, greater will be your risk taking capability (...So start early with your investment and adopt prudence to live a blissful and prosperous life.)

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