Asset allocation is the process of allocating your capital to each asset class (typically stocks and bonds) in your portfolio. Here is a simple, working model to arrive at your asset allocation for each life goal.

Say you need ₹50 lakh in your portfolio two years hence to buy a house. Now, the wealth that you accumulate is a function of your equity allocation. Higher equity can improve chances of achieving your life goal if it delivers an actual return that is higher than the required return.

The same equity allocation can lead to failure if equity fails to deliver. The issue is, volatility in equities can cause more harm than gains. Short-term volatility in equity returns can wipe out your unrealised gains or even lead to capital losses.

It takes more effort to recover unrealised losses on your equity investments than it takes to give up unrealised gains. Therefore, keep your equity allocation to a level just enough to achieve your life goal. The volatility in returns means that actual equity allocation may continually change through your investment horizon for each goal.

But how do you decide the initial asset allocation? Suppose you want a terminal wealth of ₹75 lakh in 10 years. Assuming a post-tax return of 12 per cent on equity and 5.6 per cent on bonds, you need ₹10 lakh as initial capital and monthly contributions of ₹47,000 based on an asset allocation of 70 per cent equity and 30 per cent bonds.

If, however, accumulating the terminal wealth is very important, you need a higher share of bonds. If you put 30 per cent in equity and 70 per cent in bonds, your monthly contributions increase by 4 per cent to ₹49,000. Or, your initial investment should rise by 17 per cent to ₹11.72 lakh. In essence, asset allocation is about how much equity you should have in your portfolio to accumulate terminal wealth based on your investment capital. As far as risk tolerance levels go, if achieving a life goal is important to you, you should be willing to take the associated risk.

Arriving at a number First, based on the expected return on stocks and bonds, calculate the weighted average portfolio return for different equity allocations (30-80 per cent).

Second, decide the terminal wealth you require and the time horizon for it. Third, apply the range of weighted average portfolio returns on the capital you can contribute to achieving your goal. Select the allocation that causes the least stress on your cash flows and yet helps you achieve your terminal wealth.

Periodically rebalance your portfolio because actual equity returns will be different from expected returns.

Reduce your equity allocation from age 45 till you retire to reduce your investment risk. Finally, adopt gap management to counter the risk of falling short of your goal.

The writer is the founder of Navera Consulting. Feedback may be send to >portfolioideas@thehindu.co.in

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