Two terms, asset allocation and re-balancing your portfolio, are in vogue these days. Ever since the stock market hit an all-time high, many mutual fund advisors have been asking investors to take profit and re-balance the portfolio to get back to the original asset allocation. However, several investors are a bit confused about the whole thing, as most of them have just picked up a `good’ mutual fund scheme without bothering about such finer points. Many questions abound: what is asset allocation? How does one fix the allocation? And so on.
These questions have brought back the ancient 100 minus age formula back in circulation. As per the equation, an investor can subtract his age from 100 to find out his ideal equity allocation. For example, a 30-year-old investor should invest 70 per cent in equity and 30 per cent in debt. Though many advisors use it even today to convey the concept of asset allocation to investors, the approach is not considered ideal for every investor.
“The 100 minus age equation is a very broad indicator. It may not be suitable for everybody of a particular age,” says Suresh Sadagopan, Founder, Ladder7 Financial Advisories. The biggest trouble with the formula is that it puts every individual in an age group in the same box, but individuals typically have different personal situations, different liabilities, different goals and different risk profile.
“100 minus age rule is the simplest way to determine asset allocation but it does not consider a lot of important factors,” says Prakash Praharaj, Certified Financial Planner, Max Secure Financial Planners. He offers an example of two investors who are 35 years old and want to invest for their retirement. The first one wants to retire at the age of 60 and the other wants to retire early at the age of 40. The first investor with a horizon of 25 years might be comfortable investing (100-35=65 per cent) in smallcap and midcap mutual funds. However, it would not be a wise step for the other investor with a horizon of five years to invest 65 per cent of the amount in smallcap and midcap mutual funds which need a lot of time to deliver superior returns.
However, some investment experts prefer goal-based investing to the 100 minus age formula. “Do not ever do age-based allocation. It is a very shallow and redundant method,” says Kartik Jhaveri, director, Transcend Consulting. “Goal-based investing is more scientific and works best when combined with dynamic portfolio strategy,” adds Jhaveri. In fact, even mutual funds are actively promoting goal-based investing as they believe it is simpler for investors to follow.
Yes, it is indeed easy to follow. All one has to do is to identify goals and time horizon to achieve them. For example, you have to park money for a few days. The solution is liquid fund. You have to invest for your retirement that is 15 years away. The ideal vehicle for you is equity mutual funds. Of course, the investor profile and risk profile are also taken into account while finalising the investment avenue.
The best part of the strategy is its simplicity. All you have to do is to invest according to your investment horizon and risk profile, and keep monitoring your requirement. The only jugglery you have to perform is while investing in equity to achieve your long-term goals. As you move closer to your goals, you should move your investments from equity to safer avenues like bank deposits and debt mutual funds. This is to ensure that a sudden change in market tone do not upset your financial goals.
“It depends on the time horizon whether you need to change your asset allocation,” says Jhaveri. For example, if your goal is 20 years away, you will have to change the asset allocation a few times as you will have to move your investments to less riskier assets from riskier assets as the years pass by.