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
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
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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