What should be your optimal asset allocation & why is it important
According to Investopedia, Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance and investment horizon. The three main asset classes - equities, fixed-income, and cash and equivalents - have different levels of risk and return, so each will behave differently over time.
What exactly is asset allocation?
Asset is the percentage mix of different asset classes that you may have invested in. For example - debt, equities, land or real estate, mutual funds, gold and art etc. In its simplest form asset allocation of an investor’s portfolio often refers to the percentage split between the debt and equity investments. In the Indian context, real estate, land and gold are also very important asset classes and generally the allocation to physical assets like real estate and gold is more than any financial assets like equities or equity mutual fund in the investor’s portfolio.
However, for the sake of simplicity, let us see optimal asset allocation in context to equity versus debt.
Is optimal asset allocation necessary?
The main purpose of asset allocation is diversifying the risk among the various asset classes which in simple term means not putting all your investments in one basket. For example - Equity or equity mutual funds are the riskiest asset class, but can give the highest return over a long investment horizon. Debt instruments like fixed deposits, bonds, debt mutual funds or postal savings etc. is the least risky asset class, but the returns from these investments can be assured (excepting debt mutual funds) but limited within a range.
Investors who have a mix of both equities and debt in their portfolio in the right proportion can be called optimal asset allocation which enhances the stability of their respective portfolios across all market cycles. Optimal asset allocation portfolios can generate desirable returns to meet the different life goals of the investors which can be long term or short term or both.Depending upon various market conditions, sometime equities can outperform the debt as an asset class or sometime the debt can outperforms equities in some investment cycles.
Therefore, having exposure to both these asset classes with right mix can be a win-win situation for the investors.
What should be the optimal asset allocation?
While there are many a ways to decide optimal asset allocation and different financial planners may have different views on the said topic. However, there is a very simple and popular thumb rule for optimal asset allocation – It is called Rule of 100. Rule of 100 –it means you should subtract your age from the umber 100, and the result suggests the maximum percentage amount of exposure of equities in your portfolio.
For example – Rohit is aged35, therefore, the Rule of 100 suggests that 65% (100 - 35) of his portfolio should be invested in equities and 35% in debt instruments. However, Sumit who is 55 years of age, the Rule of 100 suggests that 45% (100 - 55) of Sumit’s portfolio should be in equities and 55% in debt.Therefore, the Rule of 100 simply suggests that you should reduce exposure to equities as you age so that your portfolio can earn stable returns over a period of time while auto rebalancing the exposures between equities and debt.
Rule of 100 is very simple to arrive at the optimal asset allocation and easy to follow and is most suited to passive investors. Let us see the table below as asset allocation guidance for different age groups -
But is Rule of 100 fit for all kind of investors
The optimal asset allocation should be specific to the financial situation, future financial needs and risk appetite of the individual investors. If you are following passive asset allocation, then Rule of 100 is a good idea. But those who believe in active allocation can increase or decrease the allocation based on the above needs. For example – While young investors can have higher exposure to equities as they can have longer investment horizon, the older investors, especially those who are close to retirement or already retired may have higher proportion of fixed interest earning or other debt investments in their portfolios as their risk capacities will generally be lower.
Whether you want to follow active or passive asset allocation please note that it is the most important aspect of financial planning. Asset allocation not only helps with risk diversification and protects your investments from the volatility of capital market it also ensures that you take the calculated or limited risk based on your risk profile and age. Asset allocation also tells you that how taking too much or too little risk can harm your investment portfolio in the long run. Therefore, investors must always give adequate importance to asset allocation and ensure that they invest based on their optimal asset allocation needs irrespective of the market cycles.