How to decide Asset Allocation?
According to noted author Mr. Richard Ferri – Asset allocation eliminates the need to predict the near term future direction of the financial markets. Hence, asset allocation forms the backbone of financial planning. Let us discuss 6 such factors that influence an investor’s asset allocation
6 factors that decide Asset Allocation
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. While older individuals 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 a long term and are bullish on you 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, low duration funds, etc should be used. On the other hand for long term goals equity is the ideal asset class.
We strongly advice that 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 and avoid making such mistakes.
3. Financial Goals
One should have clarity about their financial goals. He/she should know the amount of funds required and the time in hand to meet those financial goals. Once an individual is cognizant about the above information, only then can they move forward and choose the right asset class.
The table below summarizes the respective asset class for the given time horizon.
4. No. of dependents
If an individual has more people dependent on him/her, then there would be relatively more short term goals like medical expenses for geriatric 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 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 behavior. 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. An individual should be able to identify his/her risk profile and make investment decisions taking that into consideration.
Even if a person has the willingness and financial ability to take more risk but lack the risk taking capability and cannot handle volatility. They are conservative in nature, therefore should have more debt allocation and less equity allocation.
6. Income Stability
The pandemic has opened our eyes to the fact that income stability stands as the most important of the all the factors. Features like job security, employed or self employed, regularity of cash flow, etc 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, he/she can increase allocation to equities, based on their financial goals.