In asset allocation, there’s not just one rule of thumb

In asset allocation, there’s not just one rule of thumb
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First Published: Sun, Dec 20 2009. 10 01 PM IST

Updated: Sun, Dec 20 2009. 10 01 PM IST
Frequently asked questions seldom have one right answer. For example, one of the most common questions is regarding allocation of your investment assets between stocks and bonds. There is no dearth of answers and that’s the real problem. You can’t know for sure which rule of thumb is suitable for you. But some of the standard answers available in popular investment folklores do have their own merit. We just need to do minor changes to make them suitable for individual needs and circumstances.
Johnny: Today, let’s talk about some of the basic investment-related queries. Can you first explain what does asset allocation mean?
Jinny: Making the right kind of investment which suits your individual goals, risk tolerance and investment horizon requires making right asset allocation. It is often believed that making appropriate asset allocation is the most important step in the entire investment process. What kinds of asset classes you choose decide what return you are likely to get. The task looks simple, but it requires lots of careful thinking. There are too many asset classes to choose from, such as equities, bonds, bank deposits, commodities, real estate, cash and cash equivalents. For making asset allocation, you need to decide how much you are going to invest in different kinds of assets. Say, for instance, if you have Rs100 to invest, you can put Rs40 in stocks, Rs40 in bonds and keep the remaining Rs20 in cash. There could be many other permutations and combinations. Which one would you choose?
Johnny: I don’t know what kind of allocation would suit me most. Is there any rule that I can use?
Illustration: Jayachandran/Mint
Jinny: There are, in fact, many rules of thumb. One such rule relies on your age to decide how much of your investment should be in stocks and bonds. The rule is simple: subtract your age from 100 and the result tells you how to divide your investment pie. Say, for instance, if your age is 30, then subtracting the same from 100 gives you 70, which means that you should divide your investment in the ratio of 30:70 between bonds and stocks. In other words, 30% of your investment should be in bonds and 70% in stocks. As your age advances, your investment in stock decreases whereas your investment in bonds increases. A person of 60 years of age would have 60% of his money invested in bonds or bank deposits and only 40% of money invested in stocks. Everything depends on your age. The rule seems to the say that the younger you are, the quicker your heart beats and so it is better to play your best shot.
Johnny: Sounds interesting, but tell me how sensible any rule would be that relies on your age or number of teeth in your mouth. Is there any other rule for asset allocation?
Jinny: Well, there are many other interesting views. For example, Benjamin Graham, the master of value investment, placed no reliance on the age of investors for deciding what asset one should own. You are never too young to own bonds and never too old to own stocks. You can’t rely on your age alone for deciding how much you should invest in stocks and bonds. It depends upon many factors, such as what are your investment goals, how much time you can devote, how much loss you can sustain. None of these factors are affected much by your age. A person saving money at the age of 25 for getting an MBA degree, say after two years, would be better off putting a major portion of his investments in bank deposits. Even younger people have short-term goals for which they need money lying under their mattress. Any short-term adventure in stock market may prove costly.
Johnny: What formula of allocation did Benjamin Graham suggest?
Jinny: Graham suggested that ideally one should not invest more than 75% or less than 25% in stocks. In other words, you can divide your portfolio in such a manner that at the most, 75% of your investment is in stocks and at least 25% in bonds, or 25% in stocks and 75% in bonds. You can choose any ratio by keeping a floor of maximum 75% and minimum 25% depending upon your circumstances. Graham greatly favoured a 50-50 allocation. Once you choose the right mix of assets, you just need to keep rebalancing your portfolio. This is how it works: Whenever the value of your investment in stocks rises, you sell a part of your stocks, and whenever the value decreases you buy more stocks so that the actual allocation between stocks and bonds always remains 50-50 or any other ratio that you had fixed initially. Maintaining proper balance is the key.
Johnny: Thanks Jinny. Locating the right key is often the most important step.
What:Asset allocation depends upon several factors such as individual goals, risk tolerance and investment horizons.
How: One simple formula relies on the age of an investor for deciding the allocation between stocks and bonds.
Who: Benjamin Graham, the master of value investment, said one shouldn’t invest more than 75% or less than 25% in stocks irrespective of age.
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First Published: Sun, Dec 20 2009. 10 01 PM IST