The Hindu Business Line : An approach to asset allocation

Now that you understand the importance of asset allocation to your long-term investing results, it is time to take a close look at the approach that can be used to determine your asset allocation strategy.

The basic "rule of thumb" is a mix of 80 per cent equity and 20 per cent debt (for a high risk/high return portfolio); a mix of 60 per cent equity and 40 per cent debt (for a moderate risk/moderate return portfolio); and a mix of 20 per cent equity and 80 per cent debt (for a low-risk/low-return portfolio). One may call these three portfolios as aggressive, balanced, and conservative respectively.

Determining asset allocation

A look at some basic principles. First, every investor faces the challenge of balancing downside protection (against capital loss) with upside potential (for high returns). Second, in general, people are more sensitive to loss than they are to gains of the same magnitude.

Third, the need for downside protection is also a function of the investment horizon (when you will need the money) and whether or not you are withdrawing regularly from your savings. The quicker you need the money, the more downside protection you need.

Finally, different asset classes provide different degrees of downside and upside potential. Broadly speaking, the economy can be in one of the three states: Normal, inflationary, or deflationary.

In the normal state, we do not need as much downside protection as we would in the other states, and look to equity type investments to generate high returns. In the inflationary state, we look to asset classes such as real return bonds and commodities to protect the purchasing power of our capital. In the deflationary state, we look to investment grade bonds to preserve our capital while maximising real returns.

Where should you be?

A general representation of the asset allocation for a young investor is given in the chart. The relevance of asset allocation can be brought out by the following hypothetical example:

Vishal (31) and Meena (26) are married, professionally qualified and earning a combined monthly salary of Rs 50,000 and their expenses are in the range of Rs 30,000-35,000. They expect their salary to increase by around 10 per cent per annum while inflation is expected to settle at 6 per cent.

Their current investments are: NSC VIII issue Rs 50,000; Public Provident Fund Rs 50,000; direct equity Rs 20,000; mutual funds Rs 80,000; and cash Rs 3,00,000, totalling Rs 5,00,000.

The couple is wary about their financial future and have little knowledge about principles of investing so as to get good returns.

They are averse to investing in the stock market. Their current asset allocation is given below: A look at their current asset allocation indicates several flaws. First, a lot of cash has been kept idle, not giving any returns. Second, equity composition is also small and does not help in generating good returns for the entire portfolio.

Recommendations

Principally, to meet immediate liquidity requirements, the cash reserve should be equal to two-three month's the average monthly expense.

Further, since Vishal and Meena are young and have a long career ahead, with no existing liabilities, they should look at making long-term investments in equity and debt.

As they are not very savvy about the stock market, they can invest in diversified equity through regular investments under SIP (Systematic Investment Plan) of mutual funds.

This will give them high returns over a long time-frame along with tax benefits. The recommended asset allocation for the couple would be:

This allocation is to be used for illustrative purposes only. Each investor has unique needs with regard to his/her objective, time horizon, and risk tolerance. Investors should always seek guidance from a qualified professional before implementing any programme.

(The author is CEO, Financial Planning Standards Board India. The views are of the author and not that of the organisation.)

Please send suggestions and queries to younginvestor@thehindu.co.in, or The Research Bureau, The Hindu Business Line, 859-860, Anna Salai, Chennai-600002.

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