What is asset allocation?
Investing is indeed a long-term exercise. It involves series of steps that will lead to a desired outcome. You need to follow them sincerely as it affects multiple aspects of your life. Ideally, the investing activity should begin with a goal in mind. Apart from that, you also decide upon the investment horizon and risk tolerance. Once you are done with it, then you need to select the havens which you would use to park surplus money. At this juncture you tend to ask yourself:
Where should I invest my money?
How much to invest?
When you think on these lines, you are dealing with the decision of asset allocation in the investment portfolio. Prudent asset allocation is the first step towards financial empowerment. In absence of proper asset allocation, even the best of assets like equity would fail to perform on the expected lines. Asset allocation involves assigning your resources among the various asset classes in such a manner that the risk and reward are balanced adequately to deliver desired returns. Broadly, there are three asset classes i.e. equity, debt and cash.
While building an investment portfolio, you combine these assets classes as per your goals, risk tolerance and investment duration.
How is asset allocation related to age?
Preferably, your goals drive the type of asset classes that you would like to hold in your portfolio. A short-term goal would require assets which are liquid and give moderate returns. Conversely, a long-term goal can be achieved with riskier asset classes like equity due to the availability of a longer investment horizon. But in the midst of all this, the age of the investor also plays a critical role in the selection of assets and allocation of resources thereafter.
It is based on the premise that changes in the risk-taking ability of an individual with the progression of age. A young individual who has just begun his career is in a better position to take higher risk than a middle-aged individual who has gained 10-15 years of work experience. In addition to risk tolerance, the life-stage also changes as an individual becomes older. The investment needs of an investor having dependents would be different from an investor who doesn’t have any dependents to take care of.
Hence, as the age of investor progresses, he needs to make adjustments in portfolio asset allocations to move from riskier avenues to safer havens. Ultimately, the focus shifts from earning higher returns to the preservation of capital as one approaches retirement.
How to make an age-based portfolio?
It is easy to adjust the investment portfolio according to your age and life stage. All you need to do is follow a simple thumb rule. Basically, the adjustment would entail increasing/decreasing proportion of equity in your portfolio. You can subtract your current age from 100 to know how much investment should go into equity as an asset class. So, if your present age is 25 years, then you are free to invest 75 per cent (100-25) of your portfolio in equity and the balance can be held in debt. In this way, as you approach closer to retirement, you can gradually shift your allocations from equity to debt.
In the case of mutual funds, this method can be used by means of a systematic transfer plan (STP). Here, initially, your portfolio is composed of equity funds and debt funds in the ratio of 75:25 (considering you are 25 years old). As you grow older, you can initiate an STP from equity to debt funds. The fund manager will redeem units of equity funds and purchase units of debt funds with that amount. By the time you retire, the entire corpus would have moved to debt funds. It will prevent sudden erosion of fund value on account of market fluctuations when you retire.
Age-based allocations are there to help you get the required portfolio performance. However, there are no strict rules to this. You can modify the thumb rule based on your personal investment needs and goals.