Asset allocation for long-term goals

Published: June 15, 2015 at 1:44 pm

Last Updated on

Asset allocation refers to the proportion of different asset classes in a portfolio. For example, percentage allocation to equity and debt. The allocation is (or rather should be) decided with an aim to balance risk  and reward.  The adage, “do not put all your eggs in the same basket”  is usually used to explain this strategy.

Determining the ‘right’ asset allocation for long-term goals (defined at least 10 years plus away) is a tough task if we are looking for a method to do it.  It is difficult (if not impossible) to find the ‘optimum asset allocation’ either with a risk profiler or a portfolio analysis tool.

Ideally, one should choose assets which are little or even opposite correlation with each other (one does well when the other tanks). In such a case, it is easy to use a portfolio analysis tool to determine the ‘right’ asset allocation.

Equity, fixed income (debt) and gold is one standard combination which can be used for asset allocation.

Personally I am not a fan of gold and will not choose it (too high risk for the long-term reward offered). So in this post, I will share some analysis with different equity:debt ratios.

Alok Jha has been asking me for an analysis with all three assets for a long time.  So will do this in the next post.

I choose Franklin Indian Blue Chip as representative of equity and Franklin Indian Income fund as representative as debt.  These are among the oldest equity and debt funds in the market.

We will consider a SIP from 6th July 1998 to 5th May 2014 (this was done a while back. Too lazy to update) in both funds.

This is how the XIRR will vary month by month

asset-allocation-1

 

Can we now argue that since the XIRR of the  equity SIP settles down after a while, we can have 100% equity exposure for long-term goals?

I certainly would not.  If there is a ‘big crash’ close to when I need the money, I would be in trouble. I need the bed-rock of debt.  How much of it do I need is unfortunately,  a personal choice. Hard to provide a formula for it.

This is how the standard deviation (a measure of volatility) of the monthly XIRR looks for different equity allocations. The final XIRR is also plotted

asset-allocation-2

Hate ads but would like to support the site? Subscribe to our ad-free newsletter and get beautifully formatted full articles delivered to your inbox!

Notice the bend in standard deviation at 10% equity allocation. It can be shown that it corresponds to the ‘optimum’ asset allocation in terms of risk vs. reward!

Hey we all want better returns, so let us take on more ‘risk’. But how much more is the question?!

Hard to give a mathematical answer.

I do not like a high double-digit standard deviation. I personally use 60% equity for my long-term goals and suggest no more than 70%.  I think 50% equity is also a pretty decent allocation.

Recognise that we have considered a blue chip fund. Had we included mid and small caps, the volatility would have been much higher.

I think anything about 70% equity allocation will require a lot of maintenance (monitoring, tactical calls etc.)

I have better things to do. I want something that is low-maintenance, with reasonable risk and reasonable reward.

If my net equity portfolio gives me  1o-12% after 10Y+, I will delighted. I would have met all my financial goals with reasonably low-stress levels.

Like Subra says, “the asset allocation that lets you sleep peacefully, is the right allocation!”

What do you think?

######

Register for Hyderabad Investor Workshop – June28th, 2015

 

 

Do share if you found this useful
Hate ads but would like to support the site? Subscribe to our ad-free newsletter and get beautifully formatted full articles delivered to your inbox!

About the Author

M Pattabiraman author of freefincal.comM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Linkedin
Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management.  He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.
He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, TamilNadu Investors Association etc. For speaking engagements write to pattu [at] freefincal [dot] com

About freefincal & Content Policy

Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. We operate in a non-profit manner. All revenue is used only for expenses and for the future growth of the site.
Freefincal serves more than one million readers a year (2.5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any kind of paid articles, promotions or PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)

Connect with us on social media

Our Publications


You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingMy first book is meant to help you ask the right questions, seek the right answers and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.  It is also available in Kindle format.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You WantGamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantMy second book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at low cost! Get it or gift it to a young earner

The ultimate guide to travel by Pranav Surya

Travel-Training-Kit-Cover This is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step.  Get the pdf for ₹199 (instant download)  

Free Apps for your Android Phone

All calculators from our book, “You can be Rich Too” are now available on Google Play!
Install Financial Freedom App! (Google Play Store)
Install Freefincal Retirement Planner App! (Google Play Store)
Find out if you have enough to say "FU" to your employer (Google Play Store)

Comment Policy

Your thoughts are the driving force behind our work. We welcome criticism and differing opinions.Please do not include hyperlinks or email ids in the comment body. Such comments will be moderated and I reserve the right to delete the entire comment or remove the links before approving them.

28 Comments

  1. Again a piece of noteworthy article… One can also do little micromanagement in terms of equity asset allocation, of course depending upon the age ,risk profile and goal. If some one is starting early like early 20’s for retirement goal he can bet on small and mid caps till lets say till 35’s and then convert it to diversified [~ 40’s] and then finally to debt [ 50’s]..
    What do you say Pattu Sir

    1. Yes, of course. The asset allocation need not be fixed doe the entire goal tenure. However, any changes must be made after analysing its impact on the future of the goal

  2. Again a piece of noteworthy article… One can also do little micromanagement in terms of equity asset allocation, of course depending upon the age ,risk profile and goal. If some one is starting early like early 20’s for retirement goal he can bet on small and mid caps till lets say till 35’s and then convert it to diversified [~ 40’s] and then finally to debt [ 50’s]..
    What do you say Pattu Sir

    1. Yes, of course. The asset allocation need not be fixed doe the entire goal tenure. However, any changes must be made after analysing its impact on the future of the goal

  3. Hi pattu sir,

    good post. the second graphs sheds lot of insight.

    So if we consider WORST CASE returns,

    can we say at 60% allocation it will be 16.5 % – 10.5% = 6% and at 20% allocation it will be at 7.5%

    As per your graph, WORST CASE returns will be around,

    Allocation greater than 7%
    50% < allocation around 6% to 5%
    Allocation > 70% —–> less than 5%

    If we choose mid and small cap, The volatility will be more, BUT Final XIRR will be more also, isn’t it?

    But considering WORST CASE returns, it may look the same as above,
    So may be not worthy taking the head ache

    Is this conclusion correct? or will the mid/small cap worst case return may be better?

  4. Hi pattu sir,

    good post. the second graphs sheds lot of insight.

    So if we consider WORST CASE returns,

    can we say at 60% allocation it will be 16.5 % – 10.5% = 6% and at 20% allocation it will be at 7.5%

    As per your graph, WORST CASE returns will be around,

    Allocation greater than 7%
    50% < allocation around 6% to 5%
    Allocation > 70% —–> less than 5%

    If we choose mid and small cap, The volatility will be more, BUT Final XIRR will be more also, isn’t it?

    But considering WORST CASE returns, it may look the same as above,
    So may be not worthy taking the head ache

    Is this conclusion correct? or will the mid/small cap worst case return may be better?

  5. Sir, I do not buy the theory of static asset allocation! Since the ROE depends on the dynamic variables; the asset allocation has to be dynamic. Any return on the physical asset will depend on the real interest rates while the debt returns will follow the interest rate cycle. Thank you, sir for remembering my request and the post.

  6. Sir, I do not buy the theory of static asset allocation! Since the ROE depends on the dynamic variables; the asset allocation has to be dynamic. Any return on the physical asset will depend on the real interest rates while the debt returns will follow the interest rate cycle. Thank you, sir for remembering my request and the post.

  7. And i will harp again on the Equity oriented balanced funds getting the job done just as fine..:)
    Thanks for the article Pattu.

  8. And i will harp again on the Equity oriented balanced funds getting the job done just as fine..:)
    Thanks for the article Pattu.

  9. Pattu,

    I did not understand the point “I personally use 60% equity for my long-term goals and suggest no more than 70%.”. For someone saving for retirement which is say 2/3 decades away, why shouldn’t the guy choose 100% equity? Is 60% equity cap a way to limit volatility or is it because we are not confident that equity is the best vehicle for the long term?

  10. Pattu,

    I did not understand the point “I personally use 60% equity for my long-term goals and suggest no more than 70%.”. For someone saving for retirement which is say 2/3 decades away, why shouldn’t the guy choose 100% equity? Is 60% equity cap a way to limit volatility or is it because we are not confident that equity is the best vehicle for the long term?

  11. Hello Pattu Sir, Question on dynamic asset allocation. My equity SIP has given 20% CAGR return in last 5 years. My expectation was 12% CAGR.
    My approach for dynamic asset allocation is: Sell older units bought using SIP(to avoid tax), bring down CAGR to 12% and move the proceeds to debt.
    Are there any other techniques out there for dynamic asset allocation? Please let me know. Thanks for the assistance.

    1. Your strategy will decrease volatility and the wealth that you create. There are many ways of dynamic allocation but I do not subscribe to them. I would prefer simple annual rebalancing.

  12. Hello Pattu Sir, Question on dynamic asset allocation. My equity SIP has given 20% CAGR return in last 5 years. My expectation was 12% CAGR.
    My approach for dynamic asset allocation is: Sell older units bought using SIP(to avoid tax), bring down CAGR to 12% and move the proceeds to debt.
    Are there any other techniques out there for dynamic asset allocation? Please let me know. Thanks for the assistance.

    1. Your strategy will decrease volatility and the wealth that you create. There are many ways of dynamic allocation but I do not subscribe to them. I would prefer simple annual rebalancing.

  13. I allocate 45% to equity.
    If equity moves above 55% I rebalance to 45%.
    If equity moves below 40% I rebalance to 45%.
    Rebalancing done every six months.

  14. This article is too much on conservative mode. The world is not going turn around one day as you said what if on 80% crash!. Even if so, It will be back in quick years. So one has to move all equity corpus to debt corpus while nearing the Goal say 3 yrs before the Year of Goal. And so the investment plan to be…
    I feel, I put a right argument. Lets discuss.

Leave a Reply

Your email address will not be published. Required fields are marked *