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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Sunny SachdevaAgain 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

freefincalPost authorYes, 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

Sunny SachdevaAgain 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

freefincalPost authorYes, 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

praveen thomasHi 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?

freefincalPost authorNo. You cannot such exact conclusions. All you can say is that higher the std, higher the volatility and stress.

praveen thomasHi 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?

freefincalPost authorNo. You cannot such exact conclusions. All you can say is that higher the std, higher the volatility and stress.

Alok JhaSir, 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.

Alok JhaSir, 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.

AnandAnd i will harp again on the Equity oriented balanced funds getting the job done just as fine..:)

Thanks for the article Pattu.

freefincalPost author🙂 Me too!

AnandAnd i will harp again on the Equity oriented balanced funds getting the job done just as fine..:)

Thanks for the article Pattu.

freefincalPost author🙂 Me too!

Pattabiraman MurariDynamic asset allocation is indeed possible, but we have too short a market history to determine, which is the best.

Pattabiraman MurariDynamic asset allocation is indeed possible, but we have too short a market history to determine, which is the best.

AnonymousPattu,

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?

freefincalPost authorIf you can stomach losing up to 80% up to of your folio in a crash (from above study), you can be in 100% equity

AnonymousPattu,

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?

freefincalPost authorIf you can stomach losing up to 80% up to of your folio in a crash (from above study), you can be in 100% equity

prakHello 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.

freefincalPost authorYour 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.

prakHello 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.

freefincalPost authorYour 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.

gautamThe images in this article are not visible - can you please check ?

freefincalPost authorPlease check now. Thank you.

Milind GawadeI 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.