Asset allocation for long-term goals

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

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?

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27 thoughts on “Asset allocation for long-term goals

  1. Sunny Sachdeva

    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

    Reply
    1. freefincal

      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

      Reply
  2. Sunny Sachdeva

    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

    Reply
    1. freefincal

      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

      Reply
  3. praveen thomas

    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?

    Reply
  4. praveen thomas

    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?

    Reply
  5. Alok Jha

    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.

    Reply
  6. Alok Jha

    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.

    Reply
  7. Anand

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

    Reply
  8. Anand

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

    Reply
  9. Anonymous

    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?

    Reply
  10. Anonymous

    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?

    Reply
  11. prak

    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.

    Reply
    1. freefincal

      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.

      Reply
  12. prak

    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.

    Reply
    1. freefincal

      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.

      Reply
  13. Milind Gawade

    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.

    Reply

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