Most people mistakenly believe that stock choices determine success. In reality, one of the most important aspects of investing, besides starting early — is asset allocation. This is because when you decide to invest your hard-earned money, you naturally want to minimize your risks and maximize your potential returns. And this makes it important that your investments are allocated over a variety of asset classes such as equities, fixed income, and cash; because each asset class performs differently over time due to its unique balance of risk and reward.
The process of determining which mix of assets to hold in your portfolio can be so complicated that we often jump at thumb rules. “100-minus-age” rule is a simple way to determine asset allocation. The rule says you should take 100 and subtract your age: i.e. at 40 you would have a 60% allocation to stocks; by age 65, you would have reduced your allocation to stocks to 35%. This is referred to as a “declining equity glide path” where every few years you decrease your allocation to stocks thus reducing the volatility and risk level of your portfolio.
But the “100-minus-age” rule does not consider a lot of important factors. The biggest drawback of formula is that it puts every individual in an age group in the same box, but individuals typically have different personal situations, different liabilities, different goals and different risk profile. So is determining your investment allocation by using the “100-minus-age” rule a smart approach to investing your money?
One must always remember that asset allocation that works best for you, at any given point in your life, will depend largely on your time horizon, your ability to tolerate risk and the predictability of your income. Here we discuss why it’s important to adjust asset allocation based on the volatility of income.
Salaried individuals have a regular stream of income and can opt for investment solutions that have short-term risks but give higher returns in the long term. But self-employed professionals such as lawyers, artists, architects and consultants etc. have fluctuating income as a result of the type of work that they do. This will have a significant impact on their financial situation and how much money will be available to save toward financial goals. They will also need larger buffers of liquid investments to meet emergencies.
So, if you are a common investor, then it is better to opt for the goal-based approach to investing. It is more scientific, situation-aware and helps you understand why you are saving in the first place. It places your goals right at the centre of the advice process and builds the investment strategy to fulfil multiple objectives over varying timelines.
Goal-based strategy is not about outperforming benchmarks or competitors, but about how well your portfolio is tracking against a stated goal. By investing for individual goals depending on the available time horizon and risk tolerance for each, you focus on the long-term goal and avoid worrying about the inevitable short-run volatility. You will be tracking the progress for each investment separately instead of the portfolio’s overall performance. This helps you “identify your important/ immediate goals” and ensures that you stay focused and motivated to keep investing sensibly for a long time.
Don’t Set It and Forget It
Asset allocation is all about finding the right blend of investments that works for you in the current stage of your financial journey. It is not a one time-and-done activity. As time passes and the capital markets move up and down, your target allocations can get out of sync with the original percentage allocation. And many investors take on more risk than they can handle, as they go on for years without using one simple strategy – rebalancing their portfolio. Rebalancing involves making adjustments to your investments to bring the portfolios holdings back into alignment with your asset allocation strategy.
For instance, if you have over-committed to certain sectors, then it needs to be brought to align with your asset allocation strategy. And on the other hand, you can increase the stakes if there was under-commitment to themes that look promising now. Financial planners suggest you should rebalance your investment portfolio after every big upward or downward swing in the stock market that disturbs the values of the existing pre-determined asset allocation. Hence, you should rebalance your portfolio by changing your equity allocation to 50%.
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