Dhaval Kapadia, Director – Portfolio Specialist, Morningstar Investment Advisers India, chats with Rishiraj Maheshwari of RISCH Wealth & Family Office, about how investors should decide their asset allocation.
How can investors decide their asset allocation?
There are two key determinants of one’s asset allocation - risk appetite and investment horizon or time horizon. Risk appetite means how much downside you are willing to accept in your portfolio for potential gains over your investment horizon.
Each asset class has its own risk and return characteristics. For instance, equities can be volatile in the short term and have the potential to generate positive returns over the long term. As your time horizon increases, the probability of generating positive returns from equities tends to increase and the chances of earning negative returns become nil. Thus, a longer investment horizon will allow you to invest more in equities. If you need the money in two to three years, your allocation to equities should be low as there is a high chance of getting negative returns over the short term.
How can investors ascertain their risk appetite?
Risk-taking ability can differ from one individual to another. One should look at how they reacted to different market cycles in the past when they had invested in equity and debt. For instance, if you had investments in equity during March 2020 when markets corrected sharply, how did you react? Did you sell off from equities or stayed invested?
There are a set of questions that investors need to answer to ascertain their risk appetite. Your adviser will be able to guide you to ascertain your risk appetite. Self-diagnosing your risk appetite may not be foolproof as your biases can come in your way. So it is better to consult an adviser.
Which asset classes form part of the asset allocation? Will insurance be considered a part of asset allocation?
Asset allocation is the outcome of your investment horizon and risk appetite. Typical asset classes include domestic equities, international equities, debt, gold, real estate and other alternates. Within equities, you have large caps, small caps, mid cap and sectoral allocations. On the debt side you have Provident Fund, Public Provident Fund, debt mutual funds, bonds and corporate fixed deposits, national pension scheme, and so on. Real estate and private equity can be clubbed under alternative asset class. Unit linked insurance plans can be considered an asset class since they invest in equity and debt. They are investment cum insurance products. However, term plans, which are pure insurance plans, cannot be termed as part of your asset allocation.
Should asset allocation be rejigged often?
Once you set up an asset allocation for yourself, say (50% in debt and 50% in equity) in January 2020, the allocation could have changed (60% in debt and 40% in equity) in March 2020 because the market corrected. It is important to rebalance your asset allocation in such a scenario to your target allocation. You can rebalance your portfolio back to your target allocation if there is 5-7% change in the allocation due to market fluctuations. One can review the asset allocation on an annual basis unless there is a big move in the market. Frequent rebalancing should be avoided as there are costs like exit load, capital gains, etc. involved in it.
If you build a portfolio (say 70% equity and 30% debt) that is targeted towards a particular goal, say for funding your child’s education in the next seven years, then you should reduce your equity allocation from the fifth or sixth year onwards to de-risk your portfolio.
When the portfolio is doing well say due to a sharp rally in the market, it becomes difficult to reduce equity exposure. The discipline to stick to your target asset allocation is important. This takes care of the ‘buy low sell high philosophy’.
