Determinants Of Your Ideal Asset Allocation

The ability to work out your optimal asset allocation (balance between various asset classes), and stick to it resolutely through a periodic portfolio rebalancing process is a critical success factor for long term investing success. Not only does this ensure that your portfolio’s volatility is within the bounds of your risk tolerance limits, but it also acts as a surprisingly effective guard against poor investment choices that could arise from your behavioral tendencies, primarily greed and fear.

Put simply, Asset Allocation is an investment strategy that helps you arrive at your ideal distribution between assets such as equities, bonds, cash, real estate, and gold. However, there’s no one size fits all approach to determining what your ideal number should be. What works for your friend may not work for you, and vice versa. Here are the key determinants of your ideal asset allocation, in a nutshell.

Time Horizon

The most obvious factor that contributes to your asset allocation is the time horizon you’re entering the investment with. Anything less than 3 years is too short a time horizon to expose yourself to the vicissitudes of the equity markets. For a time-horizon more than 10 years, it would be a shame to settle for just fixed income returns. Start by asking yourself just how long you’d like to invest for.

Age

Your age must be the key determinant of your asset allocation. In your early years, high risk, high return asset classes such as equities must make up the bulk of your portfolio. If markets collapse, you’ll still have time for your investments to recover and even grow thereafter. As the years roll by, you can gradually increase your exposure towards lower volatility asset classes such as fixed income mutual funds. By the time you retire, 80-90% of your assets should ideally be in low risk instruments.

Income Levels & Expenses

Your income levels are another determinant of your ideal asset allocation. If you have a high income, and can run a surplus at will by cutting out a few discretionary spends, you can afford to be more aggressive with your investments. If on the other hand, you’re living paycheck to paycheck and often leveraging yourself with credit card debt, you cannot afford to take excessive risks with your savings. Your expected growth in income levels also affect your ideal asset allocation. If you expect your income to grow at 20% per annum, you can afford to invest more aggressively that if you had expected it to stay stagnant, or grow at say 5% per annum.

Risk Tolerance

What’s your “investing personality” like? Are you a risk taker or do you shy away from anything that could lead to losses? You need to be clear on your own personal attitude to risk while making investments. Often, those who take serious risks with other aspects of their financial life (for example, choosing to be an entrepreneur leading a leveraged, startup business over taking up a secure job) tend to be more muted with respect to the risk they are willing to take on with their investment portfolios. This is a smart strategy. When assessing your individual risk tolerance levels, look at your life in entirety rather than just where your funds are parked right now.

Divisible and Liquid Assets

The current value of your divisible and liquid assets plays a key role in determining your future asset allocation. The rationale is simple – aggressive assets are going to be more volatile, and therefore less conducive to periodic drawings in case of emergencies. If you’ve already got a neat pile of money put away in easily redeemable investments, especially those that can be liquidated partially, you can afford to take a more aggressive stance with your future investments. If the bulk of your wealth is locked away in illiquid assets (such as shares of a private limited company that have only a low probability of unlocking value), you need to be a whole lot more conservative with our future investments.

Outstanding Liabilities

Last but not the least, do consider the outstanding value of all your loans and liabilities while determining your optimal asset allocation. If you lead a debt-free life, you can afford to lean heavily towards high risk, high return investments such as equities, with your future investments. If on the other hand, you are heavily leveraged with car loans, home loans, credit card debt or personal loans, your liabilities could explode in your face at any time and create a potentially dangerous situation which would require you to draw upon your savings (if, say you lose your job or your business goes bust). Therefore, the bulk of your investments need to flow into low risk, low return asset classes such as short term debt funds with low exit costs.