This post discusses various asset allocation examples for goal-based investing.
What should be the Asset Allocation for your goals?
Posted on 12 Jun 2021
Author: Sayan Sircar
8 mins read
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This post discusses various asset allocation examples for goal-based investing.
Asset allocation (AA hereafter) is the next step to be followed after a financial goal is defined. The premise of AA is, for a particular goal, to strike a balance between risky assets that generally appreciate fast (like equity) and slow-growing assets that provide stability (like debt).
The tool used to determine this mix of assets is risk profiling described in detail here. The output of the risk profiling process is a mix of equity to debt like 20:80 and a risk profile value using a simple 3 point scale: high, medium and low. This is the strategic asset allocation (SAA henceforth) for that goal.
For example, these are some typical goals with equity to debt SAA for each:
- go for a foreign vacation in 5 years with a high-risk profile - 7:93
- buy a house in 8 years with medium risk profile - 18:82
- save for children’s college education in 12 years with low-risk profile - 30:70
- save for retirement in 20 years with medium risk profile - 60:40
SAA for various goals can be combined and invested together.
📚 Topics covered:
- How to find asset allocation for goals
- What kind of return should be expected?
- Asset allocation and glide path
- What is the next step after choosing Asset Allocation?
- A note on Tactical asset allocation
How to find asset allocation for goals
The basic premise of asset allocation is a balance of the investor’s goal priority (needs vs wants) and the time horizon of the goal like this:
Here are some sample asset allocations depending on the risk profile and duration of the goal. Before using them, investors should understand their risk profile using a tool like this and be comfortable with the amount of risk they are taking.
Each row indicates the asset allocation for that particular year and will not be fixed throughout the life of the goal. This is the concept of the glide path, which says that the AA will change over time. This is because the goal comes nearer with time and the risk profile may also vary due to a change in financial conditions or extreme market movements.
For example, SAA for a 10-year medium risk goal (currently 30:70) will become a 9-year goal a year later, and the SAA will become 24:76. This will require re-balancing to be performed by selling one asset class and using the money to buy the other.
It is generally recommended that the last few years of the goal (where the SAA shows 100% debt in the table) be held in safe debt assets like bank FD or suitable debt mutual funds to ensure you can meet the goal without taking unnecessary risks.
As the table above shows equities have given positive returns historically as long as the holding period is long. Conversely, you should not invest in equities in case the holding period is either short or unknown. We discuss this point in more detail here: Should Indian investors invest 100% in equity for their goals?.
An explanation for reducing or exiting equity when the goal is close is provided here: How many bear markets have we seen in India?.
There are some thumb rules available regarding asset allocation like equity percentage of the portfolio being 100% - age of the investor. The performance of this rule is investigated in this post.
One example of using these asset allocation rule is explained in this article: How to use the bucket theory to plan for your goals?.
What kind of return should be expected?
This is extremely difficult to determine since you cannot predict the future, and past performance does not indicate future performance.
Using some assumptions below:
- equity 11% return at 15% risk
- debt 4% return at 0.5% risk these are the expected yearly return ranges for each of the SAA numbers given in the previous table:
The range is determined as:
- lower return value = -4 * risk + return
- higher return value = 3 * risk + return
The way to interpret the table is that, for example, for the medium-risk 10-year goal, the SAA is 30:70, and the return for that particular year can be between -8.2% to 15.6%. But, of course, this is an estimate. The actual return for a 30:70 goal may differ from the values given above, depending on market conditions.
As we have discussed in this post, just starting a SIP and running it for a certain number of years will not allow us to reach our goals. Instead, we need to manage risk as described in the following section.
We have covered the concept of return estimation for goals in detail here: How much returns should you estimate for your goals?.
Asset allocation and glide path
The image shows the glide path of a medium goal that starts at 60:40 and is step-wise reduced as the goal comes closer. It follows the same SAA numbers in the SAA Medium table above as described in detail here. The key takeaway is that SAA is not constant over the life of the goal due to a risk called sequence of return risk since the stock market is unpredictable. Therefore, just starting a SIP and increasing the SIP by 5-10% does not imply that you will meet the goal. This is discussed in more detail in this post on reviewing the goal’s progress.
What is the next step after choosing Asset Allocation?
Once the SAA is known for the goal, then choose the right assets to invest in, keeping in mind how suitable they are for the goal. In addition, there are multiple calculators available here based on the type of goal.
A note on Tactical asset allocation
Tactical asset allocation (TAA henceforth) temporarily changes the AA of the portfolio to act on an opportunity as per market conditions. For example, in an equity bull market, re-balancing from equity to debt as per trigger condition may be delayed to let the equity portion of the goal increase a bit more. TAA may change the portfolio’s risk profile in case the decision goes wrong and will require a more frequent review and re-balancing. There is no reason to do TAA for most investors. Ideally, a strict rule-based approach should for followed for TAA under professional guidance.
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This article shows how a single-income middle aged couple with two small children reach their retirement and children’s goals.
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This article shows how a double-income couple with a newborn child can invest for their future goals of FIRE and real-estate investment.
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This article shows how a young just-married couple can invest for future goals using the Arthgyaan goal-based investing tool.
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This article shows how a very typical salaried couple with one child can invest for future goals using the Arthgyaan goal-based investing tool.
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Topics you will like:Asset Allocation (21) Basics (8) Behaviour (10) Budgeting (12) Calculator (22) Case Study (6) Children (16) Choosing Investments (41) FAQ (11) FIRE (13) Gold (20) Health Insurance (5) House Purchase (25) Insurance (16) International Investing (10) Life Stages (2) Loans (17) Market Movements (16) Mutual Funds (38) NPS (6) NRI (17) News (16) Pension (8) Portfolio Construction (50) Portfolio Review (27) Reader Questions (7) Real Estate (6) Research (5) Retirement (38) Review (15) Risk (6) Safe Withdrawal Rate (5) Set Goals (28) Step by step (15) Tax (49)
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