A common challenge that many of us face is that there is no one-size-fits-all method for investing your hard-earned money to achieve your financial goals. You should be aware that asset allocation changes according to the life stages of an investor. It is different for a young investor as compared to a middle-aged or older investor. It’s not always a smart idea to make financial decisions on reviews, particularly those found online or via recommendations from friends and family. Also, some of the common investing tenets may not fit you.

Every investor wants to build money by reaping substantial profits from their investments. For the best risk-adjusted returns, investors should consider investing in rewarding instruments and include lucrative asset types in their portfolios. Ideally, you should diversify your investment portfolio across various instruments. The main goal of asset allocation is to allocate your money in a specified ratio among these asset classes. Any portfolio’s two main elements are equity and debt. To reach your financial goals, you must understand the right asset mix.

Recently, my friend Arjun called me up; he was looking after his investments and required some help with the same. He said, “Mitali, I have been seeking to enter the equity markets and based on our previous discussion, I am willing to invest in equity mutual funds. However, I am unable to understand a few aspects:

  • How much to invest?

  • Where to invest?

  • What should be the equity allocation in my portfolio?

To which I responded, “The secret to creating a well-diversified portfolio for building wealth is choosing the appropriate asset allocation. If you don’t make wise allocation decisions, even high-return asset classes like equities may fall short of helping you achieve your financial goals. Over time, equities may provide larger inflation-adjusted returns than other asset classes. Equity is a type of asset that is a ‘heavy hitter’ in a portfolio since it has the potential for significant growth.”

[Read: What Are Equity Mutual Funds: Meaning, Benefits, Types, FAQs]

However, keep in mind that while equity can score big, it may also strike out. Equities are a particularly risky investment in the near term due to their volatility. But investors that have been willing to ride out the volatile returns of equity over long periods of time generally have been rewarded with strong positive returns.

Traditionally, age has played an important role in equity allocation.

Age Rule for Equity Allocation:

One of the common investing tenets is that the lower the age, the higher the risk-taking appetite. This is what the 100-minus age thumb rule implies while allocating equity in the portfolio. The widely followed thumb rule ‘100-age’ dictates the percentage of the allocation made to equities. As per this thumb rule, your equity allocation is calculated by subtracting your age from the number 100.

For example, if an investor is 25 years old, 100-25, which is 75%, this would be his ideal equity allocation in the overall portfolio. The basic presumption is that as you become older, you become less willing and less able to take risks. You should thus lessen your exposure to equity. But this presumption is incorrect. Age simply cannot be the sole determinant of your equity allocation.

Here’s an Example:

Now, let’s consider two individuals, Mr A and Mr B, both aged 30 years. Mr A is a salaried individual with a working wife and a school-going kid. Whereas Mr B is self-employed with erratic cash flows, the family’s sole breadwinner and has a home loan.

When it comes to equity allocation, it is obvious that the 100-age rule does not apply to both individuals. Only Mr A, in this situation, might think of investing 60-70% of his portfolio in equities, given that his spouse provides a second source of income and there is only one dependent family member. According to rule 100-30, Mr B cannot have a total allocation of 70% in equities since he lacks the capacity to withstand the high risk and volatility that equities entail.

In addition to age, an investor’s asset allocation must be chosen based on their historical investment behaviour and preferences, goals, investment horizon, financial condition (income & savings), liabilities, number of dependents, and willingness for risk. Investors must therefore realise that the age factor considered in equity allocation is merely a rule of thumb and does not necessarily apply to everyone.

Equity allocation of any investors should be based on 3 major aspects as mentioned below:

1. Risk Profile

You have a certain risk profile as an individual investor that reflects your capacity and desire to incur risks. Willingness in this context refers to how at ease you are with taking risks and is more of a psychological aspect. On the other side, the capacity for risk can be quantified. It considers your assets, obligations, and current and projected future income. It also considers your present and expected future liabilities. In comparison to someone with few investments and significant obligations, someone with a substantial investment or asset base would undoubtedly be better able to withstand risk.

[Read: 5 Things to Consider While Evaluating Your Risk Appetite]

2. Investment Horizon

Equities are well-known for being long-term wealth-creating investments. A longer investment horizon should, in general, result in a higher equity allocation. Thus, if, as an investor, you have an investment horizon of 3 to 5 years, then a large allocation to equities might not be appropriate, irrespective of your age and risk profile. On the other hand, a higher allocation to equities is the best choice if the majority of your goals are long-term in nature and have an investment horizon of 5 to 7 or 7 to 10 years. However, this should be in line with your overall risk profile.

3. Financial Goals

Your equity allocation should align with your financial goals. When investors wish to hold the investment towards their long-term goals, investing in equity mutual funds fits the bill perfectly. It is wise to select debt-oriented funds for short- to medium-term goals, such as those with a time horizon of 1-3 years or 3-5 years. It’s crucial to match your equity allocation with your financial objectives. For example, an equity scheme may be suitable for a financial goal to be achieved after 5 years but might not be ideal for a shorter-term financial goal, e.g. a family vacation after a year. Similar to this, even while an equity scheme is thought to be appropriate for goals like retirement planning, etc., the portfolio risk must be steadily reduced by shifting such investments to debt schemes as the financial goal nears its achievement timeline.

To conclude…

Equity-oriented mutual funds have soared to the top of the list of the most preferred investment vehicles. By investing in a portfolio of companies from several industry sectors, equity mutual funds offer risk diversification, which attempts to significantly lower risks. Top-performing equity mutual funds across different categories historically have generated consitent alpha over long investment horizons. In addition to wealth creation, potential equity mutual funds are also one of the most tax-efficient investment options. In order to fulfil your financial goals for the future, you should review your investments and consider suitable equity allocation to your portfolio.

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This article first appeared on PersonalFN here


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