These are characteristics of assets that determine which are suitable for a goal.

This post covers seven characteristics of assets that need to be considered when choosing what to invest in for a goal. These considerations that determine the suitable asset allocation can be remembered using the mnemonic RRTTLLU.

📚 Table of Contents

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• Return (R)
• Risk (R)
• Time horizon (T)
• Taxes (T)
• Legal / regulatory (L)
• Liquidity (L)
• Unique situations (U)

Return (R)

Return expectation for a goal depends on goal characteristics like goal-priority, target corpus, horizon, inflation applicable and investible surplus. A quick way to classify goals are

• must-have (cannot be missed both in time and amount like retirement)
• should have (amount can be flexible like for college education loan can be taken)
• could have (these are flexible in both time and amount like a vacation: choose the destination and which year to go on vacation as per amount saved)

These will determine the return to expect from the investments to be chosen and is an input to the risk profiling process.

Risk (R)

The risk profile of an investor (see this detailed post for a calculator) depends on

• Risk-taking ability: This is a reasonably objective metric that deals with how much risk can be taken to save for a goal. Factors like high income, less number of dependants, large corpus and high skill-set in career etc., increase the ability to take more risk.
• Risk-taking willingness: This is a subjective metric that deals with behavioural aspects driven by the level of knowledge about personal finance and experience in capital markets. Things like buying a house to save tax, keeping money in savings a/c or FD due to distrust/misunderstanding of capital markets (“stock-market is gambling”), gold/real estate is the best asset class etc., are typical examples. Willingness is impacted a lot by recent market performance. Many people intend to take more and more risks in a bull market, while the opposite happens in a bear market. This tendency needs to be carefully balanced with the above two factors to ensure that unnecessarily high or low risk is not taken.

The investor will arrive at a suitable risk profile for the goal by choosing the more conservative of the two metrics above.

Time horizon (T)

In general, the longer the time horizon of a goal, the higher can be the allocation to risky assets like stocks vs safer ones since past data has shown that over long periods, there are more chances of

• getting inflation-beating returns with a higher allocation to risky assets
• recovering from short term falls in stock prices

A generalised asset allocation model based on time horizon can be:

• Less than five years: cash or FD
• Five to fifteen years: mostly debt and some equity (more equity for goals further in the future)
• Fifteen years and more: primarily equity and some debt (a classic recommendation is 60:40 ratio of equity to debt)

The general concept of sequence-of-returns (SRR) risk is applicable depending on when the money is needed. For example, if the time left is significantly less (say a 3-year goal primarily invested in equities), then there is a high risk of not recovering from an equity market fall before the goal is due.

Taxes (T)

Capital gains taxes can be complex depending on the asset chosen, the holding period, and the investor’s tax status at the time of exit. A few considerations:

• generally, short term capital gains are taxed at higher rates than long term
• income is taxed at marginal rates, unlike capital gains

Usually, the highest tax rates apply to interest, dividends, annuity income and bond coupons (like RBI bonds). Therefore, taxation needs to be considered when planning “passive income” or cash-flows during retirement.

Taxes have a disproportionate effect on compounding if deducted every year (like Tax Deducted at Source on FD), leading to the popularity of tax-deferred investment options like provident fund (PPF, VPF, EPF). This is also applicable to stocks and growth mutual funds that are not taxed unless sold.

Legal / regulatory (L)

Legal and regulatory requirements generally vary from asset to asset. A few examples:

• A minimum of ₹ 50 lakhs is required to invest in Portfolio Management Service (PMS)
• Public provident fund (PPF) cannot be attached by any court order
• Gifts are not taxed when transferred to family members, but income on that gift can be clubbed for tax purpose
• Investments in government schemes like PPF, Post Office Monthly Income Scheme, Senior Citizens Savings Scheme (SCSS), and similar plans have an upper limit
• There is a limit of $250,000 / year to invest in foreign assets under the Liberalised Remittance Scheme (LRS)
• FACTA and related regulations in different countries may restrict what countries an investor can invest in (e.g. all NRIs are not allowed to invest in Indian stocks and MFs)
• most regulators restrict private equity or investment in unlisted stocks to retail investors (this is the concept of the “accredited investor”)
• a restriction on lump sum investing in international funds by SEBI in Jan-2022. Read more: SEBI stops new international MF lumsum investments. What should investors do now?

Liquidity (L)

Liquidity describes how easy it is to convert something into cash. For example, the order of liquid assets is generally: cash > FD > stocks / open-ended mutual funds > Sovereign Gold Bonds > Gold jewellery> Closed-ended mutual funds. When investing in assets like real estate for long term goals, it is not easy to sell the asset on time at preferred rates.

Investments like National Pension Scheme (NPS), small savings schemes like provident funds, SCSS, Sukanya Samriddhi are generally locked in for long periods. This lock-in can be problematic if goals change. A classic example is a 60-year lock-in in NPS which will cause problems if the investor decides to retire early.

Also, illiquid assets like PPF, EPF which are part of the debt component of long term goals, cannot be used for rebalancing. Having a lot of illiquid assets also prevent opportunistic investments during market falls or having cash for emergencies

Unique situations (U)

Unique situations vary from one investor to another. A few examples:

• some asset classes may be less desirable for investment (like tobacco, gambling or alcohol, i.e. ‘sin stocks’)
• restrictions due to Environmental, Social, and (Corporate) Governance (ESG) considerations
• a considerable exposure to unlisted or restricted stock options can skew the portfolio composition and increase stock-specific risk
• a new investor in equity via stocks or MF may have disproportionately high exposure to debt due to mandatory investment in provident fund
• an expected inheritance can cause problems in cash flow planning and asset allocation until it is received
• similarly, an unexpected windfall needs special care and usually professional guidance for preserving and investment

Asset allocation is a dynamic process. Once it is chosen and an investment policy statement is made, a plan to review and rebalance has to be implemented. This topic is covered in detail in these posts:

• How to find out your asset allocation today?
• Rebalancing portfolio during goal-based investing: why, when and how?
• Your portfolio needs a glide-path: what, why and how?

Lastly, this post is dedicated to a dear friend of mine with whom I studied these concepts half a lifetime ago in the hostel of IIT Bombay. 🍻