Ideal Asset Allocation
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Asset allocation is an investment strategy. It helps to keep a balance between risk and return of any particular asset class. Asset allocation refers to investing a certain percentage of your investible surplus in respective asset classes, such as equity, debt, gold and real estate. Read to understand asset allocation in detail.
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Ideal Asset Allocation
- 1. Ideal Asset Allocation An Investor Education & Awareness Initiative By Franklin Templeton Mutual Fund
- 2. What Is Asset Allocation? 1 Meaning Asset allocation is an investment strategy It helps to keep a balance between risk and return of any particular asset class Asset allocation refers to investing a certain percentage of your investible surplus in respective asset classes, such as equity, debt, gold and real estate
- 3. How Is Asset Allocation Determined? 2 Age Income Expenses Assets Liabilities Time Horizon Willingness to take Risk
- 4. Age 3 Your age is one of the biggest factors in determining your asset allocation Age Risk Taking Capability 25 High 35 45 55 Low (This table is indicative, and for illustration purpose only) Age Risk Taking Capability
- 5. Income 4 Your income also determines your asset allocation Growth Rate in Income p.a. Risk Taking Capability 25% High 20% 15% 10% 5% 0% Low (This table is indicative, and for illustration purpose only) Income Risk Tolerance
- 6. Expenses 5 Consider your expenses while determining your asset allocation Growth in Expenses p.a. Risk Taking Capability 5% High 10% 15% 20% 25% Low (This table is indicative, and for illustration purpose only) Expenses Risk Tolerance
- 7. • The existing assets you hold in your investment portfolio is vital while determining your future asset allocation • Consider the concentration level of each asset in your portfolio • Never put all your eggs in one basket Assets 6
- 8. Liabilities 7 • Consider your loans and liabilities while determining your asset allocation • High interest rate on your loans leads to burden on your cash flows Liabilities Risk Taking Capability Less High More Low (This table is indicative, and for illustration purpose only) Interest Rate Cash Flow
- 9. Time Horizon 8 Consider your investment time horizon Time Horizon (Years) Risk Taking Capability 30 High 20 10 5 Low (This table is indicative, and for illustration purpose only) Longer time horizon Risk Taking Capability
- 10. Willingness To Take Risk 9 Are you ready to take high risk? Asset Class Risk Return Equity High High Real Estate Gold Debt Low Low Risk Return Risk Return (This table is indicative, and for illustration purpose only)
- 11. Case Study 10 Case Study Name Vijay Ajay Sanjay Age 30 45 60 Life Stage Unmarried Married with 2 Kids Retired Income Medium High Low Expenses Medium High Low Assets Low Medium High Liabilities Medium High Low Time Horizon Long Medium Short Willingness towards Risk High Low Medium Overall Risk Appetite High Medium Low (This above table is indicative and used for illustration purpose only. The names used in the table are fictitious)
- 12. Asset Allocation for Vijay 11 Ideal Asset Allocation for Vijay Asset Class Allocation (%) Equity 80% Debt 15% Gold 5% (This table is indicative, and for illustration purpose only) Higher risk taking capability and longer horizon translates into an aggressive portfolio
- 13. Asset Allocation for Ajay 12 Ideal Asset Allocation for Ajay Asset Class Allocation (%) Equity 65% Debt 25% Gold 10% (This table is indicative, and for illustration purpose only) Moderate risk taking capability and medium horizon translates into a balanced portfolio
- 14. Asset Allocation for Sanjay 13 Ideal Asset Allocation for Sanjay Asset Class Allocation (%) Equity 20% Debt 75% Gold 5% (This table is indicative, and for illustration purpose only) Low risk taking capability and short horizon translates into portfolio skewed towards debt
- 15. Points To Remember 14 • Invest early • Have higher future growth in Income, it increases your risk taking ability • Keep a track of your expenses • Diversify your assets • Avoid excessive loans • Longer your time horizon, greater will be your risk taking capability
Editor's Notes
- INTRO (All of us have some goals in mind such as buying a dream home, a car, travelling abroad for leisure, children’s education, their marriage and even our own retirement needs. And to achieve them, we all endeavour to create wealth by investing in various assets classes as per our risk taking capability. Some of us are conservative and want to invest only in fixed income instruments because of the fear of losing money, while some of us are aggressive and want to invest in risky asset classes to generate higher returns. But here it is vital to recognise that all asset classes do not move in the same direction at the same time. Therefore it becomes imperative for us to diversify our investments across various asset classes and invest according to our risk appetite.
- (So first let us understand, what is meant by Asset Allocation) What is Asset Allocation? Asset allocation is an investment strategy (…It helps to define a road map for your investment portfolio, with appropriate diversification across asset classes) It helps to keep a balance between risk and return of any particular asset class (…Asset allocation determines what amount of risk is being taken to earn a particular return) Asset allocation refers to investing a certain percentage of your investible surplus in respective asset classes, such as equity, debt, gold and real estate (You see, all the investments are considered separately and only a particular percentage is invested in each asset class on the basis of your risk taking capability.)
- (But the next question that arises is…) How is Asset Allocation Determined? (Asset Allocation is determined on the basis of following factors) Age Income Expenses Assets Liabilities Time Horizon Willingness to take Risk (Let’s take up each of them in more detail)
- Age Your age is one of the biggest factors in determining your asset allocation (… When you are young you can take higher risk and invest into riskier assets such as equity; As your age increases your risk taking capability decreases (But as your age increases your risk taking capability decreases and you become risk averse) (The table here shows that an individual who is of the age of 25 years has much higher risk taking capability than an individual whose age is 55 years. It happens because an individual at the age of 25 years has more time to recover from bad phase of riskier assets and therefore can afford to take higher risk. So if you have yet not started defining your asset allocation then you should start it immediately!)
- Income Your income also determines your asset allocation High income = high risk tolerance (An individual who has high income and high expected growth rate in future can tolerate higher risks. He can invest more in riskier assets) (The table here depicts that when your income grows at a faster pace, you can afford to take high risk, but when income growth rate is less your risk taking capability reduces)
- Expenses Consider your expenses while determining your asset allocation (…Your expenses are also an integral part while determining your asset allocation.) Low expenses = High risk tolerance (…An individual who has low expenses and spends wisely even in the future can tolerate higher risk. He can invest more in riskier assets) (In the table you can see if you have expected growth rate in your expenses as low as 5% as compared to an individual who has 20% expected growth rate, then your risk taking capability is much higher than the other individual.
- Assets The existing assets you hold in your investment portfolio is vital while determining your future asset allocation Consider the concentration level of each asset in your portfolio (…Some individuals are too heavily invested in a particular asset class and forget to diversify their investments. Some believe that real estate is the best asset class to invest in as it gives them dual benefit of appreciation in value of the asset and also the rental income. But what they forget is, real estate is also an illiquid asset class which cannot be sold easily in case of emergencies.) (…You should) Never put all your eggs in one basket (…so proper asset allocation is necessary to diversify your investment portfolio)
- Liabilities Consider your loans and liabilities while determining your asset allocation (…You see, your current liabilities can also affect your asset allocation. If you have big liabilities then you have a huge burden to service them and that decreases your investible surplus and also your risk taking capability. High interest rate on your loans leads to burden on your cash flows (In case you owe a lot, then you need to invest in low risk asset class such as debt, because any increase in interest rate on your loans taken can affect your cash flows negatively) (The table here shows that the lesser your liabilities, the more risk you can afford to take and vice-versa.)
- Time Horizon Consider your investment time horizon (…Asset Allocation is also determined on the basis of Time horizon for which you wish to accumulate an amount for your future goal) Longer time horizon = High risk taking ability (Longer your time horizon higher the amount of risk you can afford to take) (In the table you can see that when you have time horizon of 30 years you have a much higher risk taking capability than if you have just 5 years of time horizon. Longer time horizon leads to increased risk taking capability and higher allocation towards riskier assets classes)
- Willingness to take Risk (…your willingness to take risk determines what amount of return you should expect from your investments) Are you ready to take high risk? (…while investing ask yourself, are you willing to take high risk? If the answer is yes, you can look to have high allocation towards high return generating instruments like equity. If the answer is no, then you should identify and allocate assets for your portfolio prudently High Risk = High Return (…Do not forget, you may get rewarded for taking high risk, but there may be risk on your capital invested) Low Risk = Low Return (…if you are not willing to take risk, you will have to compromise on your returns as well) (In the table you can clearly see that Equities have the highest return expectation but also carry with them the highest risk. Debt on the other hand offers the lowest return expectation and thus the lowest risk. So if you are willing to tolerate higher risk involved in Equities, then your allocation towards Equities will be higher and you can also expect to earn higher return over the long term. But if you cannot tolerate higher risk, then you would be better-off allocating a higher percentage towards debt but at the same time it will also decrease your return expectation. You see, it is vital to define your risk tolerance first and then determine which asset class you should be investing in)
- (To help you better understand how an asset allocation is determined, let’s take an example of 3 individuals who are at different stages of their life cycle) (Vijay is a 30 year old unmarried individual, while Ajay is a 45 year old married person with 2 kids and Sanjay is a 60 year old retired individual. Since Vijay is young and has just started earning a few years back, he has only a few assets but his time horizon is around 20-30 years, so his overall risk taking capability is high. Ajay’s income is high but he also has dependents and liabilities. His time horizon is 10-15 years, so his overall risk taking capability is moderate. Sanjay is retired and only his spouse is dependent on him. Since he does not have any income, he relies on his assets to take care of his day to day expenses. His time horizon is short and therefore his overall risk taking capability is low.)
- (So what could be a suitable asset allocation for each of them…) (Well in case of Vijay since his overall risk taking capability is high and he has a long term time horizon, his allocation towards Equity should be the highest and lowest towards debt. So he can invest around 80% of his investible surplus in Equity, 15% in Debt and 5% in Gold. This allocation is expected to give him high returns but at the same time he will have an aggressive investment portfolio. He need not be too much worried about it though, as his time horizon is long term and his investment portfolio has a lot more time to recover from the short term down turn in the equity market.)
- (In case of Ajay since his overall risk taking capability is moderate and he has medium term time horizon, he can have a mix of equity and debt with slightly higher allocation towards equity. So he could invest around 65% of his investible surplus in Equity, 25% in Debt and10% in Gold . This allocation is expected to give him sufficient returns to achieve his future goals with a balanced investment portfolio.)
- (In case of Sanjay since his overall risk taking capability is low and he has a short term time horizon, he needs preservation of capital. So Sanjay should have high allocation towards Debt, slight allocation towards equity and lowest towards Gold. So he can invest around 20% of his investible surplus in Equity, 75% in Debt and 5% in Gold. This allocation will give him low returns from a low risk investment portfolio. This portfolio would be ideal for him as his main objective is preservation of capital rather than growth on investments, since he is not earning and dependent upon his portfolio for his day to day expenses.)
- (So far we have learned what asset allocation is and how ideally determining it will benefit you to diversify your investment portfolio. But before we wrap-up this session of learning, here are some points you must keep in mind while managing your finances.) Points to Remember Invest early (…As we have learnt in our earlier session, it is the early bird who gets a bigger pie. Also, as your age increases your risk taking ability reduces so start your investments early, so that you can take the benefit of a long term time horizon and possibly even be skewed toward equity for better wealth creation) (Remember if you …) Have higher future growth in Income, it increases your risk taking ability Keep a track of your expenses (…avoid any unnecessary expenses because a penny saved is penny earned) Diversify your assets (you should not be biased towards any particular asset class. Try to diversify your investments to reduce the overall investment risk on your portfolio) Avoid excessive loans (…They can disturb your asset allocation pattern. So ensure that you are not taking too much burden of managing excessive loans) Longer your time horizon, greater will be your risk taking capability (…so start early with your investment and adopt prudence to live a blissful and prosperous life.)