By following a carefully-planned strategy, investors can effectively manage their evolving financial requirements. Your investment strategy should consider various factors, including your desired return, age, wealth, risk appetite, time horizon, tax bracket, liquidity and financial goals.
Your potential returns on investment will have a direct correlation to your risk-taking ability. If you take higher risks, you have the potential to get higher returns.
What is Asset Allocation?
We are often told that investments are subject to market risk and that there is no way to completely eliminate this systematic risk. However, you can always design investment strategies to maximize risk adjusted returns. In the investment world it is said that “Never put all your eggs in one basket”. This proverb applies in the case of an ideal portfolio allocation as well.
Asset allocation refers to diversification of your investment portfolio across different assets such as equity, debt, commodities, etc. to achieve your goals. To maximize your diversification benefit, you should invest in asset classes that are not closely correlated. This would ensure that your portfolio provides a balanced return even if one or two asset classes are not performing well.
Two people can have the same financial goal, but their asset allocations may differ. For example, whoever has a higher risk tolerance may prefer to invest a considerable portion in stocks and other equity-based options. On the other hand, a risk-averse investor will put a more significant portion of their portfolio into fixed-income instruments like bonds, Fixed Deposits (FDs), etc.
Also, if a person inclines toward higher risk, they may opt for active investment strategies and try to maximize their returns. In the same way, a person with a risk-averse mindset would prefer passive investment strategies.
Why is Asset Allocation Important?
The discipline of investing is maintained by a well-balanced portfolio that avoids over or under-investment in any one area. You can divide your investment into various buckets as per your financial advisor’s recommendations. Combining different investments can help you in the following ways:
- Optimal Returns – A considerable amount of an investor’s return depends on their risk appetite, current market conditions and investment time horizon. Some risk-averse or overly cautious investors prefer investing majorly in traditional instruments such as FD or RD, leading to low returns on their investments. And some investors are too aggressive and invest accordingly, so they are unable to earn adequate returns on their investments. Proper asset allocation will help you determine how much return you can expect on your investments on the basis of investment risks you are taking.
- Minimizing Risk – Investments involve certain risks that can be minimized through diversification benefits. By diversifying into equities, bonds, mutual funds, commodities and other asset classes, you can protect your portfolio from being negatively affected by a decline in any particular asset class. However, investors should also consider the correlation between the asset classes. A low correlation between asset classes is beneficial. A negative correlation between asset classes usually indicates that they move in opposite directions. For example, asset classes like gold and equity have a negative correlation.
- Alignment Of Investments Based On Your Time Horizon: Your asset allocation depends on the time you are willing to invest. For example, suppose you wish to invest long-term. In that case, equity may be a good option as you will get sufficient time to recover from any market turmoil. However, debt securities may be less risky for your portfolio in the short term.
Asset Allocation by Age
Usually, people are willing to take risks in investments at a young age as they have a stable source of income. So, this is when they are more likely to invest in risky assets like stocks and equity mutual funds, instead of choosing relatively safer assets like bonds and FDs. However, as time passes, their risk appetite generally starts to go down, and they start rebalancing their portfolios by moving to safer options.
Along with other investments, if young investors want to keep certain assets safe for their post-retirement stage, they can invest their money in long-term bonds or schemes that would give them security after retirement.
The General Rule of Asset Allocation by Age
The idea behind asset allocation based on age is to gradually reduce exposure to risky investments as one ages. The percentage of your portfolio invested in equities is often used to reflect the trade-off between potential reward and potential risk. By subtracting one’s present age from 100, a rough rule of thumb can be applied to determine one’s equity allocation.
This rule indicates that as one ages, they should shift asset allocation away from equities and toward safer assets like fixed income assets and debt funds. For example, let’s say an investor is 35 years old. Then 65% of the investor’s portfolio can be invested in equity linked assets, and the other thirty-five per cent could be in other safer asset classes.
As retirement nears, they might start diversifying their holdings away from equities and into debt.
Limitations of this Approach
The most evident limitation of this approach is the assumption that all young investors are risk takers and with age the risk appetite reduces.. This may not be true for all investors. This is because no other factors have been considered while making this rule.
It is important to note that asset allocation is not a one-time decision, it involves life-long adjustments and fine-tuning. While this process varies from individual to individual, few simple rules can help you allocate your resources in line with your evolving needs at different life stages.
Asset Allocation for People in the Early Stages of their Career
People often have the misconception that you need a lot of money to start investing. But, if you have just started working, you can start with the smallest sum of money; even Rs.1,000 can be invested in assets like mutual funds or stocks as a beginner. You can also start a Recurring Deposit account if you have a lower risk tolerance and seek moderate returns. It all depends on your personal goals, risk tolerance and funds available.
While people in the early stages of their career are open to the idea of investment, they may need a clearer idea of reasonable asset allocation. Limited liabilities at this stage makes it possible for you to take more risk and include a higher proportion of growth instruments like equities in your portfolio. As your income starts rising, you can also add some debt instruments to your portfolio for short-term financial needs.
Asset Allocation for People at a Career Peak
Once you start earning and have a growing source of income like a salary or business income, you can start investing aggressively for your financial goals. As your income will be growing, you will also have a higher disposable income.
People at their career peak are usually within the age group of 30 to 50. Being a part of this age group, you may have your future goals set and may be clear about how you want to proceed with your savings and investment. You may have certain liabilities on your shoulders, and your risk appetite may have decreased compared to before.
If you have not started investing earlier, you might have to invest a major portion in stocks as compared to debt instruments. In case you have already started your investment journey, you can consider rebalancing your portfolio between equity, debt and cash.
Asset Allocation for People Nearing Retirement
At an old age, it would not be a wise decision to put your money at risk. So you should allocate a higher part of your portfolio in safer assets like bonds and other fixed income instruments. If you have made significant gains in your equity linked investments at a young age, then you can allocate those funds in instruments that give monthly cash flows. Also, opting for liquid investments would be more beneficial as any need can arise at any time.
Between 50 to 60 years of age, your liabilities may be less as your children may have become financially independent. However, your flow of income will be coming to a halt. Start planning your retirement based on your current circumstances. A reasonable allocation may include less quantity of risky securities like equity and more securities like debt.
It is not as simple as it may seem to define an optimal asset allocation because many considerations must be made before an individual can reap the rewards of a carefully curated portfolio. However, once a person has implemented a sound asset allocation strategy, they will start generating a reasonable return consistent with other constraints like risk, taxes, liquidity and time horizon. However, rebalancing should be considered within adequate time frames.
FAQs about Asset Allocation by Age
Is this general rule of asset allocation applicable to everyone?
Since this rule does not consider factors like time horizon, liquidity needs or expected return, it only applies to some and should be followed after proper research and consideration.
Is 30 a very late age to start investing?
No, it is not a very late age to begin investing. Although starting investments early is better, no age is considered very late to begin investing.