To grow one's capital, it is important to decide how much money is to be invested in equity, debt, etc rather than choosing which equity or debt mutual fund to invest in. This is called asset allocation as it entails where to invest and by how much.
Asset allocation refers to how much of your money is to be parked in different assets: equity, real estate, gold and so on. In the case of mutual funds, asset allocation refers to allocating money between debt and equity mutual funds.
Debt and equity mutual funds have many sub-categories. Equity mutual funds can be categorised as largecap, smallcap, and so on. Likewise, the sub-categories in debt mutual funds include liquid funds, ultra-short term funds and short-term funds.
Each of these sub-categories offer different kinds of returns and are associated with varying levels of risk.
Why is asset allocation important?
If you observe the markets, you will notice that all types of assets rarely perform in tandem. Till recently, the IT sector was doing poorly even though most other sectors were performing well.
When markets as a whole perform poorly, investors start to invest in debt mutual funds. The latter has continued to perform even while equity markets are doing poorly. On the other hand, when equity markets outperform, investors flock to invest in the hopes of earning higher returns.
One might think it best to invest in mutual funds that perform the best. This is called timing the market. Unfortunately, even the best investors are not successful in timing the market.
So, it makes sense to allocate investments in a mix of mutual funds. When one set of funds perform poorly, the others will balance the underperformance.
Investing one's entire capital in a limited type of mutual fund is a risky strategy. If one had invested only in equity mutual funds around 2008, the portfolio could have suffered losses. But investing in debt mutual funds would have delivered decent returns. At the same time, if one invested only in debt over the past few years, one would have earned far less returns than someone investing in equity mutual funds. The trick is to invest in all types of mutual funds by diversifying.
There are a number of strategies that one can choose for allocating capital to different kinds of mutual funds. But to keep things simple, here are the four most popular strategies.
Coffee can strategy
Coffee can strategy refers to investing a fixed amount in different types of mutual funds for the very long term. This rule is hard to follow as there will be instances when changing conditions will make it unavoidable to keep one's asset allocation constant.
For example, a few years down the line, one may want to go on an international vacation that was never planned for earlier. If such a big expense comes up, one will be bound to make portfolio changes.
This could, however, work for a part of one's investments, where one puts a portion of your existing investments in a coffee can portfolio and let it compound that way for a very long duration.
Fixed percentage strategy
As the name suggests, the percentage you invest in equity and debt remains constant and does not change with time.
This means you will need to regularly rebalance: if the value of investments in equity mutual funds increases, one is are supposed to sell some units and invest the same in debt mutual funds and vice versa. The end goal is to keep the percentage of your investment in all types of mutual funds constant.
While using this strategy, one's future goals, plans, big expenditures, etc all need to be factored in.
One of the biggest hurdles with this investment rule is that it is very hard to decide what percentage to opt for. This is largely because there are always expenses that are hard to predict. One might want to buy a new car in the future that hadn’t been planned for. Or, one may want to shift to a city where the living expenses are higher.
That makes it nearly impossible to keep the decided percentage constant.
100 minus age strategy
Subtract your age from 100. The answer is the percentage of funds that should be invested in equity mutual funds. The rest should be invested in debt funds.
For example, if your age is 25, then 75% of your total investments should be in equity funds and the rest (25%) should be in debt funds. This rule is extremely popular with investors.
What this rule does is reduce your exposure to risk as you age. As one grows older, one would invest more in debt funds which is a low risk investment.
But this strategy has one major downside as it automatically assumes your risk appetite will reduce with age. However, if you are old but live below your means, you can still afford to take more risk. That’s where the flaw in this strategy lies.
This strategy leads to another problem. Thanks to better healthcare, people are living longer lives. Which means, they will require more funds for their retirement than they anticipated. By investing heavily in debt, you are causing your money to grow at a slower pace. This might result in lesser funds to meet one's lifestyle.
On the flip side, if you are young, the strategy would imply you invest greatly in equity. If at that time the markets suffer, you could incur losses on your equity investments.
Market dependent strategy
This strategy relies on market conditions to decide one's allocation to different kinds of mutual funds. What this strategy advocates is constantly rejigging investment allocation based on the market conditions.
When equity markets are moving upwards, one is supposed to increase investments in equity funds. On the other hand, when equity markets are on a downward trend, one is supposed to increase investments in debt funds.
This investment strategy is not for everyone as it involves a great deal of work. One cannot just invest and forget. One will need to constantly keep selling and buying to follow this strategy.
If volatility is high, one stands to lose as the chances of selling and buying right before the market trends reverse is very high.
Not just that, given that one will be needed to make so many changes, one will pay a large part amount as transaction charge.
Which asset allocation strategy to adopt?
With asset allocation, there can be no one rule that fits everybody. Each person’s financial condition is different and requires a different approach.
In fact, I would go one step ahead and say no person’s financial condition remains the same. This means that one would have to change their investment strategy from time to time.
What one can do best is to be aware of their finances and use the asset allocation strategy that suits their financial condition at any given point in time.
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