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Why asset allocation is key to staying calm

In uncertain times, the volatility increases and the swings are large. The common investor can find this stressful and confusing. In times like these, your asset allocation can be a major contributor to your stress levels or can help with reducing it.

Stock markets by their very nature are choppy at all times, and while long term trends suggest an upward trajectory, they can go either up or down in the short to medium term. In uncertain times, the volatility increases and the swings are large.

Most investors find this stressful and confusing. In times like these, your asset allocation can be a major contributor to your stress levels or can help with reducing it. There is an appropriate asset allocation for all of us depending on the life and wealth stage that we are at. But before we get into that, here are some rules that apply irrespective of age;

1. You should have an emergency fund equivalent to 6-12 months of expenses, invested in a liquid instrument like a liquid Fund or an RD.

2. Your fixed income/debt funds allocation should be primarily for objectives that you intend to meet in the next 3 years to 4 years and a good thumb rule is to have an amount that will see you through 2-3 years of no earning. If you are nearing retirement, this amount should be higher.

3. Your equity allocation is primarily designed to grow your wealth for the long term, and thus should be higher during your early and higher-earning years. 

4. If you also invest in gold, then this should ideally be kept to less than 10% of your overall corpus. Gold mutual funds and ETFs are a better way to do this as compared to owning physical gold.

Age-wise asset allocation 

As a thumb rule and to keep it simple, we’ve married asset classes, equity and debt (fixed income) to age appropriateness to get you started. However, please take professional help in deciding asset allocation that works for you according to your individual circumstances, current savings and investments, income level and goals.  

FIXED INCOME

Debt mutual funds should be the fixed income instrument of choice given no lock-in period, low taxes upon withdrawal, and returns that are at least on par with fixed deposits. Depending on the kind of investor you are and your objectives, you would have a certain allocation of your portfolio to debt mutual funds. And if you have invested in them, choosing the right type of debt fund, as there are several, iis crucial. To keep it simple, we have only discussed the recommended types below;

1) If you are invested in liquid funds

Your age is Below 35: Smart move. Do nothing to existing investments. This is your emergency fund due to its stable nature, freedom from market movements, and high liquidity. A certain portion of your savings should be going here, depending on how certain your income is. The more uncertain, the greater the portion here. A good thumb rule would be 6 to 12 months of your expenses.

Your age is 35-45: Smart move. Do nothing to existing investments. This is your emergency fund due to its stable nature, freedom from market movements, and high liquidity. A certain portion of your savings should be going here, depending on how certain your income is. The more uncertain, the greater the portion here. A good thumb rule, if you are a single-income family with kids, at least 12 months of your living expenses should be set aside, accounting for EMIs and school fees.

Your age is 50-60: You are closer to retirement and it would be a good idea to increase your investments here. You should ideally move your retirement corpus in a phased manner to debt mutual funds such as liquid and ultra short term funds when you are 3 years away from retirement. 

Your fixed income/debt funds allocation should be primarily for objectives that you intend to meet in the next 3 years to 4 years and a good thumb rule is to have an amount that will see you through 2-3 years of no earning. If you are nearing retirement, this amount should be higher.

2) If you are invested in debt funds other than liquid funds 

Your age is Below 35: If this includes ultra-short-term and short-term funds, then stay invested and do nothing. Use this for any short-term needs that may arise. If you are invested in riskier debt funds such as credit risk funds, move to short term and ultra short term funds at the earliest. 

Your age is 35-45: If you are largely invested in ultra-short-term and short-term funds, then stay invested and do nothing. Use this for any short-term needs that may arise. If you are invested in riskier debt funds such as credit risk funds, move to short term and ultra short term funds at the earliest. You should not be invested in high-risk debt funds at all. 

Your age is 50-60: At this stage, it is crucial to check the kind of debt funds you are invested in. It is recommended to be invested in ultra-short-term and short-term debt funds, given market volatility and the nature of debt funds.

EQUITY

Equity is the primary asset class when it comes to building wealth over the long term (7-10 years at least) due to its ability to stay ahead of inflation. The primary ways to invest in this asset class involve direct equity (stocks), ETFs, and equity mutual funds.

Within mutual funds, there are multiple categories such as large-cap, multi-cap, large-cap and mid-cap, mid-cap, small-cap, focused, index etc. 

The majority of long term objectives of investors can be met through investing in large-cap and multi-cap categories. The reason is simply that large-cap mutual funds typically are invested in the biggest, and thus the most stable and reliable companies. Their share prices tend to be far less volatile than smaller companies. Multi-cap funds, on the other hand, invest across market capitalisations and thus try to be invested in both today’s stable market leaders and tomorrow’s giants which are minnows now. While they showcase greater volatility, they also allow an investor access to potentially better long term growth.

1) If you are invested in equity mutual funds 

Your age is Below 35: At this time of major volatility and the market downturn, even if you are invested in the best equity funds, you would be seeing losses. It is critical to stay invested especially if you have chosen large-cap and multi-cap. Continue your SIPs. However, ensure your emergency fund of at least 6  months of expenses is fully funded first. Another thumb rule some people use is: Emergency fund amount = four months of your current salary.

Do not withdraw from equity funds unless you have no other sources to meet any urgent and critical requirements. At worst, stop SIPs and use it to fund requirements you had not planned for.  

Your age is 35-45: Even if you are invested in the best equity funds, you would be seeing losses, at this point in time. It is critical to stay invested especially if you have chosen large-cap and multi-cap funds. Continue your SIPs. However, ensure your emergency fund of 6 months of expenses including EMIs is fully funded first. In fact, boost the emergency fund now as you would likely have dependents and expenses such as school fees which are non-negotiable in the short term.

Do not withdraw from equity funds unless you have no other sources to meet any urgent and critical requirements. At worst, stop SIPs and use it to fund requirements you had not planned for.  

Your age is 50-60: At this stage, your asset allocation should have an increasing mix of fixed income products. Your equity portfolio is to ensure your overall retirement corpus stays ahead of inflation. If more than 60%-70% of your investments are in equity, then it would be prudent to continue investing but preferably in ultra-short-term and liquid funds.

 Withdrawing now, unless absolutely necessary to meet urgent requirements, could result in your corpus not being enough to meet requirements when you have no other source of income.

In Summary

The idea of good asset allocation is to make sure occasional underperformance in one asset class (such as equity) doesn’t adversely affect your life and ability to meet your objectives. 

More than 60-40 or 50-50 or 30-70, it is about balancing asset classes based on your savings, life stage, and what you want to achieve.

 

This article first appeared in the Economic Times on 1 April 2020

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