When we are constructing portfolios we always think about asset allocation. Asset allocation is the key driver of portfolio returns and studies have proved that.
Asset allocation should not be static
One thing that often gets missed out on is that asset allocation is not a static concept, it is an evolving concept. So, it is important to set the context of how your asset allocation would look not just today but for the future too, towards meeting your goals. This is where the glide path concept becomes very important.
Let me use the analogy of an aircraft. When the aircraft is approaching its destination, it changes its altitude and speed to land safely.
When you are investing in various asset classes – equity, debt and cash - for a goal which could be retirement or whatever it is 20-30 years down the line, you can start with a very equity-heavy portfolio which is a great long-term asset class but volatile in the short term.
But as you go along on your journey, it is important that you start cutting your exposure to equities because there can be events such as the COVID crisis where equity value erosion can happen quite significantly in a very short span of time.
So, the glide path essentially advocates that you start moving from the more volatile asset classes to a safer and more conservative asset class over a period of time as you start approaching your investing goal in order to have a smooth landing.
Should the glide path be known at the start of the investment journey?
It is important to have this construct in mind for two reasons. When you construct a portfolio for a goal 30 years down the line, you are making some assumptions. You decide on a target corpus. You do these calculations based on fixed asset allocation, say 80% equity and 20% and this is how much I need to invest.
You have some estimate of return in mind and the time taken to achieve that goal. When you use the glide path approach, you move from equities to fixed income. So your return estimates need to factor that in. You need to have a ballpark amount in mind when you are putting down the glide path. You will make changes as you go along but it is essential to have a broad construct right at inception.
Can you use target maturity funds?
Target maturity funds are very popular in markets like the U.S. These funds could be a part of the portfolio, but each person is unique in his/her own circumstances and goals. Asset allocation is not just linked to age. It is also linked to your finances, cash flow requirements from your portfolio, time horizon and so on.
So target maturity funds can be one part of the portfolio. They can be used for achieving certain goals like funding your child’s higher education, which is certain. Alternatively, these funds can be used as part of the overall asset allocation.
The right formula for glide path
If you have 30-year time horizon for your portfolio, one can start with an aggressive allocation to equity and let the portfolio nurture itself for the first 10-15 years. You can start cutting your exposure once you are approaching your goal. It can be a gradual shift at first and the curve can be steeper in the last few years because you want to safeguard your portfolio. It is a rough guide as the exact quantum of shift would depend on your circumstances.
