Investments and risks go hand in hand. It’s true, that no returns are generated without risk. What you investors cannot avoid is the systemic risk which is inherent. Systemic risks are risk arising from economic turmoil, political instability, natural calamities, etc. To put it simply, these are unavoidable risk which you investors have to bear with. However, to the other side of the coin are the non-systemic risks which can be controlled and managed. Fund managers need to be efficient and knowledgeable enough to keep these risks at minimum. Some of the non-systemic risks which fund managers need to manage are company specific risks, liquidity risks, concentration risks (portfolio concentration), etc.
Again you as an investor can manage these risks (non-systemic) by carefully allocating your hard earned money to different asset classes. Let’s see how this can be done effectively.
While you are willing to take risk, you need to recognise that risk is a function of your age, income, expenses and nearness to goal. So, if your willingness to take risk is high (aggressive), you can skew your portfolio more towards the equity asset class. Similarly, if your willingness to take risk is relatively low (conservative), your portfolio can be skewed towards fixed income instruments, and if you are a moderate risk taker you can take a mix of 60:40 into equity and debt respectively. While investing, practicing this exercise and adopting the SIP mode in mutual funds, can create wonders for you as volatility of the markets will be managed well through rupee-cost averaging, and wealth can be created through power of compounding.
The Thumb rule
While we recognise that figuring out the right asset allocation can be daunting task for many of you, you can simply go by the ‘Thumb rule’ too - which is 100 minus your present age. So, for example if your age is 30, 70% (100 - 30) of your money can be invested in equity and the rest 30% can be invested in debt instruments. Hence by having a 70% allocation to equity you are classified as an "aggressive investor", as your willingness to take risk is more.
Asset allocation by thumb rule
(Source: PersonalFN Research)
Allocation based on nearness to goals
While one may go with the thumb rule for asset allocation to diversify one’s portfolio, but allocating your investments to different assets like equity, debt and gold based on the ‘nearness to goal’ criteria is not a bad idea too.
This concept of allocating the funds to different asset classes based on your nearness to goals helps not only to diversify risks across different asset classes but also in rebalancing your portfolio when you are closer (in terms of number of years) to the achievement of financial goals. Let us observe in what proportion one can take exposure to different asset classes based one’s nearness to goal.
(Source: PersonalFN Research)
So as you can observe from the pie charts above, if your goals are 10 years away from the realisation of your financial goals you should be allocating dominant portion towards equity (i.e. 75%), 10% towards debt and 15% towards gold.
Remember gold as an asset class commands its place in any portfolio may it be aggressive, moderate or conservative. It is an asset class which has shown a secular uptrend and has an inverse relationship with equity thus providing stability to one’s portfolio.
Similarly, if your goals are just 5 years away from the achievement of your financial goals then your asset allocation changes as equity 55%, debt 35% and gold 10%. And finally if one is just three years away from their goals then you need to put your entire corpus in debt so that it is free from volatility of the stock markets.
We believe that one may follow any of the above style to allocate your assets. But remember one thing before replicating any of the above strategies you must first jot down your risk taking ability taking into consideration your income, expenses, no. of dependants in your family, age, etc. In this way you will be able to achieve your goals in a prudent manner without taking undue risk.
Also, please remember to adopt the systematic investment plan (SIP) route to your investments in mutual funds. This will help you to take advantage of the rupee cost averaging and the power of compounding.