Virender has been in confusion over the last few years. He has an investment portfolio heavy on real estate which is not doing good now. So he wants to change his allocation by including more assets. But as he read and met few advisors he got a wide view on what asset allocation he should follow.Friends or relatives have always thrust him to be heavy on real estate while different other views tell him that he should look at his age to invest.
Advisors have sent him few questions also which by answering he will be able to know the asset allocation. But till now he is unable to understand those questions.
There is no one fit for all answer for asset allocation approach. How you should construct your investment portfolio and what mix of assets you should follow is based on your financial situation. While many advised a standard age formula financial planners go by the actual assessment of one’s risk tolerance.
So what is the right approach and what are those standard formula which tells you about your asset allocation.
Let’s review some of the methods by which you can allocate your assets and where they stand for your portfolio construction advice:
1. The Age Formula
This is most general advice given to all investors, Invest in equities according to your age. So if you are 24 then (100-24=76%) is what you should be investing in equities. Similarly if you are in fifties then (100-50=50%) is what you should be investing in equities. Although these are kind of thumb rules they cannot be taken as an outright advice, simply because at age 24 you might not be able to invest more while at age 58 you may be in situation to take higher exposure in equities. The other strategy based on age is to start with an asset allocation and keep decreasing the exposure with your age. Check NPS auto allocation feature which is based on such strategy. If you start with 50% equity investment at age 35 or below then every year the exposure in equities is trimmed based on a lifecycle matrix. This may be good for investors who cannot decide on asset allocation and wish to keep it low at higher age but surely not a standard formula to consider.
2. The Risk Appetite
You may be at whatever age your risk appetite will decide what asset allocation you follow. So even nearing retirement you are ready to take a higher risk in equities while in your 30s you are not keen to go even for 50%. This difference primarily happens when you may or may not be free from responsibilities or you may or may not be knowledgeable about the markets. If you do not have dependents or are free from your liabilities then you are in a position to take high exposure and so your asset allocation approach will be tilted more towards one asset class i.e. equities.
3. The Thumb Rules
There are certain thumb rules which float around for investing your money. Exposure in equities as per goal horizon or investing as per your loss tolerance level or have a 50-50 approach are some of them which has been popular. But thumb rules cannot work out rightly and one need to look at various other factors to see if these make sense in your financial decisions. Check here some of the common thumb rules used in investing-
4. The Risk Assessment
One of the more common approach taken by most advisors is having a risk assessment. So you are asked few questions and on the basis of answers you are guided what exposure you should take in which asset class. Here, If your financial situation is not analyzed in detail then this strategy will run into troubles as just 5 or 15 questions cannot judge you risk taking capacity unless other variable like goal horizon, your liabilities etc. are assessed.
5. The Friends Advice
Most investors go by friends advice and so if a friend had made money in a good stock they do the same. Or if have a friend investing from long time then you treat him as an expert and go by his advice. But remember that every financial situation is unique and what he can adjust with is completely different from what you can do. Your friend may be free from liabilities or have already adjusted for his goals which you may not have done. So depending on other advice without knowing your situation is not the right approach for your asset allocation.
What Approach To Take?
Asset allocation depends on many factors. Your age, do you have dependents or not, your liabilities, your current financial situation i.e. how much you are able to save and what provisions you have done for your goals, your current investments, and many others. Unless you analyze these factors you will not be able to decide how much you should be investing in what asset class. There are some investments which may not suit your situation. You cannot invest in them just because someone else has made money. Also, thumb rules or advice based on only one-factor analysis are incomplete and may ruin your investments. The asset allocation approach should be based on your financial roadmap and not on few set of questions.