One of the most difficult questions I have been asked by clients over the years has been - What is the correct asset allocation? Unfortunately, unlike in science or more so in mathematics, where whatever method you use, there is only one correct answer: there is no correct answer.
While we rely more and more on science and math, investing continues to be an art. Sensing it is bad manners to not answer a client’s question (it may cost you the relationship itself), we tend to derive simple answers to a complicated question. It is obvious that we may not have all the answers upfront, and some questions may be too difficult to answer, but most of us do not have the courage to accept that in front of the client. So what can be done? This is where plurality comes in. Just as one size doesn’t fit all (at least not comfortably), there is no one answer for everyone.
Fortunately, there are factors that you can assess in the quest for finding a unique asset allocation that suits you the best. These factors include the discretionary nature of money, the time horizon for investment and your risk appetite.
Firstly, let me start by saying that any loss is painful. The loss of even a Rs. 100 note fallen from your pocket hurts, so let us get this straight that there is no use putting up a brave face when the portfolio is in losses. The trick is how you manage this pain and that is what asset allocation is all about. Secondly, and equally important is that there is no perfection here. You cannot get it right all the time. You may be lucky when a stock shoots up just when you bought it.
Apart from earning you bragging rights with your friends, it proves nothing. With the benefit of hindsight (which crystallizes the fuzzy future), you could have always done better. So use hindsight only to learn for the future, rather than fret over what you could have done better. That is a lost case.
Coming back to asset allocation, the discretionary nature of investments also means the inverse of rigidity of your goals. Some goals like saving (or paying installments) for a house, or for higher education of children are top priority and need to be met. Such liabilities reduce the room to negotiate around the asset allocation matrix. If most of these have been taken care of, or are not there in the near term future plans, then a more flexible (risky) asset allocation plan may be considered.
Time horizon for investments means that in goals like costly higher education of children or planning for post retirement income, if these are far away today, more risks can be taken so that there is opportunity to ride through a rough patch or correct a wrong decision, but if these are coming up shortly, the ability to take risks is curtailed significantly.
Lastly, risk appetite is practically impossible for others to measure for you. General comments you receive saying ‘I think you can take this risk’ are utterly useless and may actually be biased towards getting your investments onboard. It is in fact extremely difficult for even a highly experienced investor to get his own risk appetite right. I can attempt to give you a starting point, from where you can probably work your way forward. Please try to take as much risk, in terms of losing money, in the worst case scenario, that you can tolerate.
Some people have a lot of money, but get really stressed out if they are making losses, others may have much less, but are more relaxed during trying times. As I said, losing money hurts, but the trick is to not get anxious about it. If you are losing sleep due to your investments, your asset allocation is definitely wrong. Asset allocation is a long term evolving exercise. Better knowledge, increasing experience, new alternatives and changing personal conditions mean that the asset allocation will need frequent revisions and that is okay!
(The author is the founder of Five Rivers Portfolio Managers and can be reached on firstname.lastname@example.org)