Now that we all agree that our portfolio should have cash, bonds, stocks and real estate, how much of each should one own? That is asset allocation and it depends on fundamentally two things – your investment horizon and your ability to take risks. As a rule of thumb, longer investment horizons and higher risk taking ability mean you should invest more in equity mutual funds and real estate.
We all practice asset allocation, even if we don’t call it by that name. If all your money is lying in your checking account then your asset allocation is 100% cash. If you have 20% in fixed deposit then your asset allocation is 20% savings, and 80% cash. If you also own a house which is fully paid for and roughly worth 20% of your net worth then your assets are allocated 20% in savings, 20% in real estate, and 60% in cash. The choices we make on what to buy and where to keep our money invested is called asset allocation.
Different assets have different return profiles.
Cash is the safest asset, but it yields nothing. Fixed deposit is equally safe but not as easily accessible as cash and gives you a higher rate of return. Stock market through mutual funds are as accessible as fixed deposit but carry short term risk of capital loss, but have higher long term rate of return than fixed deposits. Real estate has long term returns similar to stocks but requires a lot more effort to buy and sell. On the plus side, you can live in the house you bought, which is not possible with other financial assets (cash, savings or stocks).
Risk: Reward: Liquidity of various assets –
Risk: Cash < Fixed Deposit < Mutual Funds = Real Estate
Reward: Cash < Fixed Deposit < Mutual Funds = Real Estate
Liquidity: Cash > Fixed Deposit = Mutual Funds > Real Estate
Ideally you should work with a fee-only financial adviser, like us, to figure out your specific long term financial needs (buying a house or car, kids education, parental support, retirement etc) and risk appetite to tailor the asset allocation for your stage of life. In case you want to do it on your own, here are four simple rules of thumb to follow when it comes to Asset Allocation
- Have six month to one year of expenses in cash or easily accessible fixed deposits to pay for unexpected contingencies (loss of job etc)
- Of the surplus income, invest (110 – Age (in Years)) in equity Mutual Funds and remainder in bond Mutual Funds. For example if you are 40 years old, buy 70% in equity mutual funds and 30% in bond mutual funds. Choose low cost index mutual funds.
- Re-balance your portfolio to (110- Age)% in equity mutual funds and rest in bond mutual funds every 2-3 years.
- Buy a residence to live in once you have the requisite investment amount.
The above does not take into account your risk appetite or your goals, both of which will materially affect your exact asset allocation. Nevertheless it is a simplistic time tested asset allocation framework and not a bad starting point.
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