Factors that influence asset allocation
What is asset allocation?
Asset allocation means diversifying your investment portfolio into various asset classes such as equity, debt, gold, etc. However, the proportion allocated to each asset class will depend on factors such as the investor’s age, risk profile, life events, investment time horizon, income tax benefits, how close the investor is to achieving the financial goal, etc. In this article, we will discuss these factors that influence asset allocation.
Importance of asset allocation
The various asset classes that you can consider for diversifying your investment portfolio include:
- Equity: It involves investing in equity shares of companies, either directly or through equity mutual funds. Equities are risky, but also have the potential to give inflation-beating high returns. Equities can give income in the form of dividend and capital gains.
- Fixed income: It involves investing in debt instruments such as debt mutual funds, fixed deposits, small saving Government schemes, bonds, etc. They carry low risk and give low returns. Fixed income instruments can give you income in the form of interest. If they are sold before maturity, there can be capital gain/loss.
- Gold: It involves investing in gold in the form of gold ETFs, gold mutual funds, sovereign gold bonds, digital gold, etc. Gold acts as a hedge against inflation. It can give income in the form of capital gain.
To read more about various asset classes check this article on importance of asset allocation. Before we understand the factors that influence asset allocation, let us understand the importance of asset allocation. Your investment portfolio returns depend on various factors, but asset allocation is the key factor in that.
As seen in the above chart, your investment portfolio returns majorly depend on asset allocation. Hence, it is important to get your asset allocation right. Your asset allocation, in turn, depends on various factors. Let us now discuss these factors that influence your asset allocation.
Your age is one of the biggest factors that can influence your asset allocation. You should start investing at a young age, preferably as soon as you start earning. When you start young, you give time for your investments to enjoy the power of compounding and create wealth for you.
Rule of 100: Many financial experts recommend the “Rule of 100” for age-based asset allocation. As per this rule, the equity allocation of your investment portfolio should be: “100 minus your current age”. For example, if you start investing at the age of 23, you should start with an equity allocation of 77% (100 – current age 23 years = 77% equity allocation).
As per this rule, the remaining 23% asset allocation can be towards other asset classes such as fixed income, gold, etc.
As your age increases, you should go on decreasing your equity allocation by 1% every year and increase your fixed income allocation by 1%. Please note, the Rule of 100 considers only your age for determining your asset allocation. However, along with age, you also need to consider other factors and accordingly arrive at the appropriate asset allocation.
- Risk profile
An investor’s risk profile demonstrates the risk-taking ability of the investor. Your risk profile directly influences your asset allocation. An investor’s risk profile can be classified as one of the following:
- Aggressive risk profile: These investors are willing to take a high risk if there is a potential to earn high returns. For example, equity mutual funds have high risk but have the potential to give inflation-beating high returns.
- Moderate risk profile: These investors try to strike a balance between risk and returns. They are willing to take a moderate risk to earn moderate returns. For example, balanced mutual funds or multi-asset mutual funds have relatively lower risks than pure equity funds.
- Conservative risk profile: These investors are not willing to take high risks; hence they have to be content with low returns. For example, gilt mutual funds or liquid mutual funds have low risk, but their returns are also low.
As an investor, you can decide your equity allocation based on the amount of risk you are willing to take. You can use the below table as a guideline to decide your maximum equity allocation.
As seen in the above table, your maximum equity allocation is directly proportional to the amount of risk you are willing to take. So, the higher the willingness to take the risk, the higher can be your equity allocation and vice versa.
- Life events
Life events such as marriage, childbirth, taking a home loan, etc., can have an impact on your asset allocation. These events can reduce your ability to take the risk and hence lower your existing or future equity allocation. If not planned properly, events like marriage, a home loan, etc., can also impact your cash flows and hence influence your future investments.
- Investment time horizon
The investment time horizon is the number of years you have to fulfil your financial goal. Based on the investment time horizon, financial goals can be classified as follows:
- Short-term financial goals: Any goal with a timeline of up to 3 years may be classified as a short-term financial goal. Some of these include building and maintaining an emergency fund, purchasing term life insurance for family bread earners, purchasing health for the entire family, building a fund for annual vacations, etc.
- Medium-term financial goals: Any goal with a 3-7 years’ timeline may be classified as a medium-term goal. Some of these include purchasing a car, building a fund for a home loan down payment, building a fund for an international vacation with family, etc.
- Long-term financial goals: Any goal with a timeline of more than seven years may be classified as a long-term goal. Some of these include building a fund for a child's higher education and marriage, home loan repayment, building a fund for retirement, etc.
Classification of financial goals into short, medium, and long-term goals influence your asset allocation, specifically, equity allocation. You may use the following guideline for equity allocation based on the investment time horizon.
As seen in the above table, the longer the investment time horizon, the higher the equity allocation can be. For short-term goals (0-3 years), you should not make any equity allocation. On the other hand, for long-term goals (7 years and above), you can start with maximum equity allocation and gradually reduce with every passing year.
- How close are you to achieving your financial goal
In the case of medium and long-term financial goals, with every passing year, you should review the asset allocation and go on reducing the equity allocation and increase the debt allocation. Once you reach a stage where there are less than three years left to accomplish the goal, you should shift the remaining equity allocation to debt.
- Income tax benefits
Well, for some people, income tax benefits are the starting point for asset allocation. Ideally, this should not be the approach. Your asset allocation should be based on factors like age, risk profile, investment time horizon, etc. Based on these factors, you should decide the asset allocation. Once the asset allocation is decided, you should choose financial products in those asset classes based on income tax benefits.
While considering financial products, you should look for income tax benefits:
- At the time of investment,
- During the accumulation phase, and
- At the time of maturity/redemption/claim, etc.
Other things being constant, any financial product that gives you income tax benefits at all three levels should be given preference over other financial products.
Risk profiling with Glide Invest App
In the above sections, we have discussed all the factors that influence asset allocation. However, for your asset allocation, you can partner with the Glide Invest App. You can do your risk profiling by just answering a few “Yes” and “No” questions. Based on your risk profile, your asset allocation will be decided, and you will get the recommendations for suitable mutual fund schemes. You will get advice on how to plan and systematically invest towards your financial goals.
With Glide Invest, you will get guidance for:
- A personalised risk profile assessment
- Identifying your financial goals
- Appropriate asset allocation
- Making a financial plan for each goal
- Automating the financial plan
- Review and analysis of your financial plan
- Hand holding you till your financial goals are achieved