For a given financial goal, how do I determine the asset allocation? That is, how do I decide the amount of equity exposure and therefore, fixed income or debt exposure? Let us try and discuss this and use a calculator to see how different asset allocations will affect the future corpus intended for a financial goal.
Step 1: Decide equity exposure
There is no formula to decide the right equity exposure. There is no right way or wrong way. We need simple personalized thumb rules. I would like to base my rules based on rolling returns of an index like Sensex or Nifty.
This is what I would do:
For goals less than 5 years away: no equity exposure.
Between 5-10 years: Not more than 40% for an important goal and about 60% for a less important goal.
Between 10-15 years: 40-60%
Above 15 years: 60%.
I like to stop at 60% because of this: Asset allocation for long-term goals
Step 2: Have a return expectation
For me, this is also based on analysis with past data. I have several posts on this. Here is just one:
What Return Can I Expect From Equity Over the Long term? Part 1
Above 15Y, I expect no more than 12% from equity. Anything above 14% is nuts.
Between 10-15Y, 10%
Below 10Y, 8%.
For debt, just the post-tax return from FD for the duration you have in mind: 6-7%.
Step 3: Calculating expected portfolio returns
Once you decide on the equity exposure, and the return expected, you can calculate the expected return from the portfolio.
Equity exposure: 60%. Return expected 12%
Debt exposure: 40%. Return expected 7%.
So the portfolio return = (60% x 12%) + (40% x 7%) = 10% (after tax).
Step 4: How much can I invest?
Now I need to know how much I can invest each month for this goal, and how much I can increase this amount each year.
Step 5: What is my target?
What is the present cost of the goal that I have in mind. What is reasonable rate of inflation associated with this expense. What is the future cost of the goal for the time duration that I have in mind?
Step 6: Minor adjustments
All the above steps are independent and can be performed in any order. With the above inputs, the next step is to find out if the target corpus can be achieved.
Any current investments have to be taken into account. All my goal planners and retirement calculators do this. I have not included this in the current sheet as it might become too messy.
If yes, the next step is to start investing.
If no, minor adjustments could be to the investment amount, rate at which it increases, equity exposure, return expectations to meet the target.
The sheet presented can help you do this. Instead of using step 3, I have used XIRR. This requires the use of an Excel macro.
Download the financial goal asset allocator
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That is fantastic approach to decide on the asset allocation…… These days, not active on FB, so do not know if this has been discussed there by you..
thank you
That is fantastic approach to decide on the asset allocation…… These days, not active on FB, so do not know if this has been discussed there by you..
thank you
I need a calculator on the same lines but for lump sum investments for the financial goals.
Easy enough to make it with the above sheet. Not interesting enough for me.
I need a calculator on the same lines but for lump sum investments for the financial goals.
Easy enough to make it with the above sheet. Not interesting enough for me.
The file gives error and goes on the debugger if equity taken as 100%….Hope you can explain and rectify
It is not meant for use with 100% equity! So nothing to rectify. If want to check with one asset class, set the return for debt and equity to be same.
The file gives error and goes on the debugger if equity taken as 100%….Hope you can explain and rectify
It is not meant for use with 100% equity! So nothing to rectify. If want to check with one asset class, set the return for debt and equity to be same.
Pattu, You say that for any goal less than 5 years away, there should be no equity exposure. So does this mean that when your retirement is 5 years from now, should you be liquidating all your equity investments and put them on more safer debt and fixed income instruments or you should stop any fresh investments on equity. But isn’t this more riskier when the retirement years stretch longer with longevity and the funds you have accumulated over the working years may not be sufficient enough to cover the cost of living during the later years
For goals other than retirement, exiting equity that way is good. For retirement, one can go in for a more gradual de-risking depending on the amount of corpus at hand. For example, if one has 60% of equity it could be reduced to 30-40% or so depending on need and risk appetite.
Dear Pattu sir,
You have assumed a portfolio return of 10% The equity component is 12%. I personally feel these are on the higher side if you have to go by long term nature of global trends. Moreover for the last 5 years Sensex 20 year rolling return is sliding. Hence it may not be possible to reach the assumed asset-liability match in goal settings.
It looks only alternative is to increase the quantum of saving year on rather than assume unrealistic quantum of return.Hope I am not sounding pessimistic.
It is always good to be pessimistic! Hopefully one can invest the extra sum.
Is it advisable to consider the PF part as the debt portion of long term goal portfolio? PF (40%) and Equity (60%) for long term? I mean to say that no other Debt instrument other than the EPF.
Let’s say Monthly investment required for retirement goal is 10000. And my monthly EPF (including employee and employer contributions) is 4000. Then rest 6000, I will put in Equity. Is it advisable?
Pattu Sir, one area which I found quite tough is to decide where to deploy the debt portion of the portfolio. For example, I have ~5 different long term (10+ years) goals and the asset allocation I am targeting for each one of them are around 70% Equity and 30% Debt. What is your advice (or how are you handling the investment for the debt portion). The PF component I have accounted for retirement goal (and there also I need more debt allocation to meet 30% definition). Should I be just investing in short term debt funds as the return is relatively less risky at around 8%? Or is there a better way to deploy this money? Appreciate your advice.