It has always been our contention that you should spend your leisure time with your family, not worrying much about how your investments have weathered the market.
In this spirit, we discuss this week why you do not have to use sophisticated models for asset allocation. Asset allocation is the process of dividing your money into various asset classes such as equity, bonds, commodity and real estate. Our view is that you can follow a thumb-rule allocation policy and still hope to achieve your investment objectives.
Technical issues
Typical asset allocation models require you to input several variables. It is sufficient to know that asset allocation models require complex input forecasts and are best left for professionals to use. Besides, there are two other reasons why we suggest that you start with thumb-rule allocation.
One, the actual returns that you earn year-on-year will be different from the expected returns used to design an asset allocation policy. If the actual return in any year is lower, you have two choices to work towards your investment objective.
You can increase your investment contribution to the portfolio. Or you can sell bonds and increase your equity allocation to compensate for the lower-than-required return.
Two, you may experience changes to your lifestyle. On the positive side, you may inherit ancestral property or win a lottery. On the negative side, you may suffer health-related issues which may force you to cut back on your professional work and, hence, your standard of living.
So, even if you use sophisticated asset allocation models, you will still need to change your portfolio composition regularly .
Your asset allocation is a function of your risk tolerance level. This, in turn, is dependent on your ability and willingness to take risk. While the ability to take risk is based on variables such as your current income and wealth, your willingness to take risk is psychological. You will be less inclined to take risk just after a market crash than before one! And unless you follow a disciplined approach, you will be tempted to sell your equity investments when market crashes and invest that money in bonds.
Any such move may derail your investment objective because your original asset allocation was based on a pre-defined path — how much equity you should have during your investment horizon to achieve your investment objective. So, why use mathematically-rigorous models to arrive at an asset allocation when you are vulnerable to changing the portfolio composition during adverse market conditions? This brings us to a related issue. Sophisticated models can sometimes lead to complacency. Using asset allocation model may draw you into an illusion of preciseness about market expectations and the possibility of reaching your goal. You are, hence, subject to more regret when actual returns fall short of expected returns. A thumb-rule may not lure into such illusion because you are aware that it is just an approximation.
Equity allocation
You should start with 63 per cent equity allocation, not more than 10 per cent to commodity and the rest in bonds. Why 63 per cent? Typical asset allocation requires equity investment between 50 and 75 per cent. And 63 per cent is half-way between the minimum and maximum equity allocation!
Remember, your portfolio, whether based on thumb-rule or on a sophisticated model, will have to be rebalanced many times during your investment horizon.