Simple Asset Allocation Strategies For Varying Risk Profiles

Asset allocation is the single most important factor in ensuring financial success. In the broader sense, asset allocation includes a variety of asset classes like equity, fixed income, gold and real estate. Of this,equity, fixed income and cash/cash equivalents form the financial assets, while gold and real estate form physical assets. For the purpose of simple explanation, we will restrict to equity and debt. 

Abhishek Agarwal 
Director, Eastern Financiers Ltd

 

Please note that your asset allocation should be specific to your long and short term financial goals and your current financial situation. For example, if you are on a sabbatical from work for a certain period of time, your asset allocation should be on the conservative side with more of fixed income assets. 

On the other hand, if you are an entrepreneur and your income is irregular, then significant cash equivalents like money in savings bank account or liquid mutual fund investments is required to sustain during lean periods. However, equity emerges as the best asset class for long term financial goals. Likewise, if you are nearing to achieve a goal timeline, then you should shift to fixed income assets so that your goal is not compromised because of market volatility. 

Let us now discuss few simple asset allocation strategies for some generic risk profiles. 

Asset allocation based on Maximum Loss Percentage 

The concept of Maximum Loss Percentage brings some quantitative objectivity to evaluation of risk appetites. Maximum Loss Percentage(MLP),as the name suggests, is the maximum portfolio (which includes both equity and fixed income) loss than you can suffer, without causing any financial distress to you. Emotional or financial distress can cause you to trigger panic selling, which can cause financial loss. However, MLP will differ from investor to investor as their risk capacities and risk attitudes can differ. For some investors, it can be 10%, while for others it can be 50% or even higher. The formula of equity allocation in terms of MLP is as follows 

Maximum Loss % + Risk Free Return Equity Allocation (%) = Maximum Market Loss % + Risk Free Return 

What is the Maximum Market Loss? This is the worst case scenario for the market. For most investors, 2008 was the worst bear market in India. The Sensex fell by 60% from January to November 2008. The asset allocation based on a 2008 like scenario will prepare us for the worst. 

Let us walk through an example to see how the formula works - 

Let us assume that your maximum loss percentage is 20%, i.e., you are ready to suffer 20% reduction in your total portfolio value without panicking even in a situation like 2008. Assume the risk free rate (fixed deposit rate) is 8%. Your equity allocation based on Maximum Loss Percentage will be (20% + 8%) divided by (60% + 8%) or 41%. This is the maximum equity exposure you will have. Let us examine a scenario where the market falls by, say, 35%. Your asset allocation, as discussed earlier, is 59% fixed income and 41% equity. Your portfolio loss will be (59% X 8%) – (41% X 35%) or -9.6%, well within your tolerable limit. Even if the market falls by 50%, your loss will -15.8%, which is still within tolerable limit. 

If you are young and have stable income, you can have a high maximum loss percentage(50% or more), depending on your financial situation as you can afford to wait longer for market to recover and recoup losses. On the other hand, if you are nearing retirement or an important goal, you cannot wait for long and hence you will have lower maximum loss tolerance. Asset allocation based on MLP is quite practical as it is based on how investors react in adverse situations and protects their interest in such situations. 

Good old strategy - 50/50 Asset Allocation 

Some financial planners suggest this strategy of having equal exposure to both the assets – equity and debt. It makes intuitive sense, especially for new investors. In fact, hybrid aggressive funds (earlier known as Balanced Funds) are supposed to work on the same principle, even though in India the asset allocation of hybrid aggressive funds is around 65/35 for availing equity taxation. 

A 50/50 asset allocation strategy with asset rebalancing from time-to-time can work well for investors with moderate to moderately high risk profiles. 

“Ration for the Worst Case” - Asset Allocation strategy for senior citizens
 

Popular US finance author, Darrow Kirkpatrick, shared in his blog an asset allocation strategy for senior citizens. He called it “Ration for the Worst Case”. Though Kirkpatrick’s strategy is a little too conservative, the beauty of this strategy is its simplicity. Let us understand it through an example - 

Suppose you are nearing retirement or just retired (at the age of 60), assume your retired life will be 30 years long and annual expenses are `8 lakh. In this strategy, you will invest an amount equal to 15 years (half of your retired life), i.e. `1.20 crore in total (`8 lakh X 15) in low risk fixed income products, e.g. short duration debt fund. Let us assume that the post-tax debt fund returns will at least match inflation rates, say 6-6.5%. Using this strategy, you can make annual/quarterly/ monthly withdrawals from your debt fund investment to meet your expenses for the next 15 years. So, irrespective of what happens in equity market, you can comfortably carry on with your inflation adjusted expenses for at least first 15 years. 

The question is how will you meet your expenses for the next 15 years? This is where the equity allocation comes into play. The beauty of this strategy is that there is no reliance on income from equities for the first 15 years, thereby allowing it to compound and create substantial wealth which can help meet your income needs, for the rest of your life. Why is this strategy effective? Because, this strategy not only takes care of first 15 years of your retired life, but also creates sufficient wealth for the next 15 years. 

Age-Based Asset Allocation Strategies
 

The Rule of 100 is a popular asset allocation thumb rule. Simply put, you subtract the investor’s age from 100, and the result suggests the maximum percentage of equity investment. So, for a 30 year old investor, this rule suggests that 70% of his/her portfolio should be invested in equities and so on. This model is ideally suited for a passive investor.

Some financial planners may suggest that Rule of 100 can result in sub-optimal allocation to equities in retirement years. They may argue, age expectancy and longer retired lives and rising inflation require us to have higher allocation to equities. Therefore, instead of Rule of 100, some suggest the Rule of 120 to take care of post retirement income needs. Let us see the asset allocation guidance for different age groups, according to Rule of 120.

To conclude, you can choose a strategy or even try to mix various strategies and form a hybrid one that works best for you. At the end of the day, the best strategy is the one which works for you.