I. Introduction to Asset Allocation

Asset allocation is the process of committing your money in multiple asset classes like equity, debt, cash, real estate, to balance risk and reward.

It is a crucial step in the investment planning process, as it helps investors to achieve their financial goals while managing risk. Since asset allocation reduces volatility and diversifies your risk, the expected weighted average return of such a diversified portfolio could be lower than “putting all your eggs in one basket” e.g., equity which carries significantly higher risk.

II. Understanding Asset Allocation

The goal of asset allocation is to achieve a balance between risk and return by investing in a diversified mix of assets that align with the investor’s risk tolerance, time horizon, and financial goals. There are various approaches to asset allocation namely strategic asset allocation, dynamic asset allocation and tactical asset allocation.

Combined with periodic rebalancing, i.e., selling a portion of the investment that is over its target allocation and buying more of the investment that is under its target allocation, an investor can stick to their overall asset mix.

III. Factors to Consider when Creating your Asset Allocation

When creating an asset allocation, there are several factors that should be considered. These factors include:

• Investor’s financial goals: The financial goals the investor hopes to achieve through their investments. These could be building a corpus for an emergency fund, purchasing a minor or major asset, higher education, travel, retirement etc.
• Investor’s time horizon: Is the investor investing for the short-term, medium, or long-term?
• Investor’s risk tolerance: Grable defined financial risk tolerance as “the maximum amount of uncertainty that someone is willing to accept when the outcomes associated with the decision are uncertain and potentially negative”. Risk tolerance is a subjective assessment, evaluated through a revealed-preference or a propensity scale questionnaire. SEBI requires that investment advisers mandatorily carry out regular risk assessment of their clients.
• Investor’s risk capacity: This is an objective assessment of the investor’s ability to withstand a loss. According to Grable & Carr (2014), risk capacity is a function of the client’s net-worth, amount of insurance, income, risk management etc.
• Investor’s risk perception: These can change based on market events, volatility, change in life circumstances or life transitions like greater family responsibility, loss of employment, promotion, retirement, divorce etc. According to Carr (2014), experience of past events, overconfidence, mood, familiarity, representativeness, can impact risk perception.
• Investor’s risk knowledge: This refers to the investor’s knowledge or understanding of the risk associated with investing in an asset class.
• Cash-flow: The monthly resources that can be allocated are limited to the cash-flow surplus available after accounting for the household living expenses.

IV. What are the key steps for an investor to determine their desired asset allocation?

Step 1: Determine your goals: What are you investing for? Is it a long-term goal or a short-term goal? Is it a flexible goal like buying a house, family travel abroad, retirement etc. or a non-flexible goal like planning for your child’s under-graduation expenses? You also need to calculate the corpus required based on likely inflation for that goal.

Step 1: Net worth: Can any of your assets be allocated towards paying for your future goals? E.g., EPF/VPF/PPF/Gratuity can be allocated towards retirement. Equity investment holdings can be allocated towards a medium or long-term goal. Savings bank balance/FD can be used as emergency funds. Calculate your current asset allocation based on savings and investments.

Step 2: Determine your risk tolerance: Your advisor should have a dialogue with you after asking you to complete the risk tolerance questionnaire (RTQ). Though regulators require that RIA’s regularly conduct risk assessment of their clients, there is no standard format or questionnaire mandated by SEBI.

Step 3: Discuss your risk profile: Your advisor should have a joint discussion regarding you and your spouse’s answers to your respective RTQs to understand the reasoning behind the answers as well as have a conversation about risk. This is essential since both of you are highly likely to have differing risk tolerances.

Step 4: Risk capacity: Having an emergency fund of 6 to 12 months expenses, sufficient term insurance coverage to protect your family, health insurance coverage, cumulative savings, etc. can improve your capacity for risk. However, risk capacity and risk tolerance are different attributes and increase in the former does not imply an automatic increase in risk tolerance.

Step 5: Improve your risk knowledge: Understand the risks associated with investing in different asset classes or financial products. E.g., Understanding the relationship between interest rates and bond prices.

Step 6: Determine your need for risk: The amount of risk an investor needs to take to accomplish a given goal. You also need to determine the projected return you are expecting from equity or debt or other any other asset class that you would like to invest in. Highly optimistic real return projections, based on past performance, are unrealistic and will force you into taking on high-risk products to achieve essential goals.

Step 7: Cash-flow surplus: You might need to prioritize investing for certain goals depending on the amount of surplus available for investment.

Step 8: Desired allocation: Now that you have taken all the above factors and steps into consideration, work out the amount you want to commit each month to your chosen investments.

Step 9: Rebalancing the Portfolio: This step involves regularly reviewing the portfolio and making adjustments as necessary. This can include selling or purchasing investments to maintain the desired asset mix.

V. Conclusion

There is no one-size-fits-all approach that will determine your family’s asset allocation. Your goals, your investment horizons, your priorities, you and your partner’s risk tolerance, your need and willingness to take risk, your net worth, among other factors, play a role in determining your asset allocation.