We’re back with the final chapter in our “Personal Finance” series. Through this series we’ve given you a fair bit of information of what personal finance is, the 5 Effective Mantras for Financial Fitness, Four Smart money moves you must make to improve your finances. We thought helping you understand how much equity you can have in your portfolio was fitting to round off this series.
Shall we begin?
Have you seen anyone invest in an asset and not expect to profit? Well, we haven’t yet. Every investor invests with an idea to profit from investments. That’s why choosing the best stocks, fixed income and short-term instruments with care becomes imperative.
Wondering how much of a pie should you keep aside for fixed income, bonds and equity? Yes, all investors have thought about this sometime. Before we decide on a number let us understand asset allocation.
Asset Allocation: Earning an income is not rocket science. But to become wealthy, an investment plan for long-term is what you need. Invest early if you want to achieve your goals.
Devoting a sum based on hearsay will not help you. Choosing the right asset allocation based on your risk profile is the right approach. Asset allocation is a tactic where you spread your surplus amount across assets such as stocks, FDs, cash, gold, and others to balance your risks and rewards.
No two people will have the same asset allocations despite the same financial goals. For example, Investor A with higher risk tolerance allocates more money to equity than FDs and bonds and Investor B with low risk tolerance allocates more to FDs and bonds and less to equity investments.
Does this mean just allocating is enough? No. Getting the asset allocation right is vital. That’s why asset allocation plays an important role in portfolio management.
Asset Allocation in Portfolio Management
Having the highest-return generating equity won’t help unless you have prudently allocated your funds. An optimum asset allocation is the key to financial liberation. Earmarking lets you understand where to invest, how to invest, and how much to invest?
However, your age plays a crucial role while deciding on asset allocation and portfolio management. Remember, every investor is different so, the asset allocations will also differ. It means you cannot have a one-size-fits-all asset allocation. What’s more, as you age the allocation also changes based on your life-stages.
Like Investor A, at 20 has a high-risk capacity and appetite so he invests a larger amount in equities. At 30 he reduces the equity share some and adds to his fixed-income investments. The same investor at 50 reduces his equity investments by 50% and increases his debt holding significantly.
The graph above shows how Investor A’s asset allocations may change based on his age and stage of life.
Other factors such as risk appetite and risk capacity also influence your asset allocation. Risk appetite is your comfort with market fluctuations and fall in your investment value. Risk capacity is your financial tolerance to losses in investment.
Example, Vinay, a 30-year-old works in an MNC and earns a good salary. But his investment portfolio has debt funds and other fixed income instruments. In such a case, Vinay will be a conservative investor. Though his age and financial health mean he can invest in equity, his low-risk appetite makes him to the opposite.
We’ve just told you, your Age affects asset allocation like your risk appetite and risk capacity. But how these three factors influence asset allocation? Let us understand the fundamental principle underlying the relation between the three factors.
Relation between age, risk appetite and asset allocation
Your risk appetite is inversely proportional to your age. It means as you age your capacity to take financial risks reduces.
When you are young, your capacity to earn is high, which means you can move on to better opportunities and increase your income. However, after retirement your savings may happen to be the only source of income. It means your capacity to take risks is minimal.
Does this mean after retirement an investor cannot invest in equity? No, investors can invest in equity anytime if they have the risk capacity and tolerance.
The rule of the thumb for asset allocation principle is a rule where your exposure to investment risks must reduce with age. It refers to the proportion of equity in your portfolio as they offer higher returns at greater risks.
To know how much you can invest in Equity, just subtract your age from 100. It means if you are 20, your equity allocation would be 100-20 = 80. It means 80% can be equity-oriented investments and the rest can be fixed-income instruments and debt funds. Similarly, for a 65-year-old his equity allocation would be 100-65 =35, i.e., 35% in equity and the rest 65% in debt and other fixed assets.
Does this hold true always? No. This rule emphasizes the long investing horizon of the investor over his/her risk taking ability. It also focuses on allocation modification based on age alone, without considering other factors.
Example: A young investor may have the age, but is struggling to earn enough to fulfill his EMI payments and meet unexpected needs. Though he has age on his side, he maybe dipping into his wealth too often and have little or no savings to absorb any investment losses.
On the other hand, an elderly investor, may have a short investing horizon, need more income than growth and be wealthy enough to bear the possible risks of equity investments. These examples show the rule of the thumb used for equity allocation is not always right. Neither does your age decide your allocation completely.
If you can hold the investment for a long time; choose growth over income, and tolerate losses without risking your wealth, then you may want to invest in Equity.
We’ve seen the different factors that can affect your asset allocations, the relation between them, and how only your age cannot define your equity ratio in optimal asset allocation. Let’s see how much your equity allocation should be
Your equity allocation can start off as a 50:50 ratio, where half your wealth is invested in growth-oriented products like equity and the remaining half can be in income generators like fixed-income assets, bonds, etc.
Make changes to this ratio based on your situation. If you have a steady and rising income, regular and growing savings, no debt and rising wealth after considering inflation then investing 80% of your money in equity makes sense.
However, if you feel you aren’t meeting all the conditions then reduce your equity exposure to 60%. Lower your risk exposure for condition you cannot meet till you have a minimum of 20% investment in equity.
The one rule you may want to follow though is fixing 25x of your annual spend as your wealth creation goal.
Your age does not decide your retirement. However, if you have enough wealth that can generate the money you need to spend normally then you can retire. Keep this rule in mind when you decide on your financial goals.
Remember, your wealth is based on your income, spend, and asset allocation. Have a system in place that will help you become wealthy enough to not work for your everyday needs.