Finer Nuances Of Financial Planning Aspects - III : Asset Allocation

Previously in this series, I have covered the nuances behind setting goals and meeting insurance requirements. The natural next step would be to begin constructing our portfolios. The exercise of portfolio construction begins with defining an asset allocation. Let me begin by saying that there is no optimal asset allocation. It is a purely subjective decision. But there are a number of factors that affect the asset allocation for a particular goal. Factors such as nature and tenure of the goal are primary and obvious factors at play in this decision. Let us look at the deeper factors that influence asset allocation decisions. 

Gender

An individual's gender has a direct impact on the way they think and make decisions. Males are typically more adventurous by nature. They are naturally inclined to be outcome oriented. They are likely to prioritise achieving a higher return even at the cost of taking incremental risk. A higher allocation to riskier assets such as equity in the portfolio may therefore suit them better. 

Females on the other hand are relatively more risk averse. They are a lot more process oriented in nature. They are likely to require a clear understanding of the rationale behind a decision for them to fully buy into it. They typically prefer to take just as much risk as they need to. A balanced allocation to multiple assets may therefore represent an optimal solution for them. Couples may need to reach a middle ground between the male's preference for greater risk and the female's preference for balance when deciding an asset allocation. 

Income Profiles

Salaried professionals and those with tenured designations such as government officials would have a stable source of income. They can therefore afford to have an increased allocation to risky assets like equity in their portfolios. In case of entrepreneurs, freelancers and self employed professionals the income earned would be lumpy and inconsistent. They would already be exposed a significant degree of risk due to the nature of their jobs. Potential for growth in their line of work is usually high. Therefore their portfolios should ideally be skewed towards safe assets like bonds and fixed income.

Risk Profiles And Their Relevance To Asset Allocation Decisions 

An individual's risk profile has an obvious impact on their asset allocation. Any individual's risk profile is usually built on two aspects. These are risk capacity and risk tolerance. Risk capacity shows how much risk an individual can afford to take. Risk tolerance shows how much risk an individual is willing to take. Some risk profiling tools also provide for risk requirement. It represents the minimum level of risk an individual needs to take to achieve their goals.

These aspects can each be assigned a score. The combination of these two scores results in the risk profile score. A high risk profile score is usually associated with a higher allocation to risky assets. But the risk profiling exercise is usually carried out in a controlled environment. The individual participating in the exercise is given time to think before responding. Their responses may not therefore offer a holistic understanding of their risk profile. They only reflect their perceptions of risk given their prevailing life circumstances. For example, someone may be open to a moderate level of risk under normal circumstances. Assume they have lost their job just before they respond to a risk profiling tool. Their responses are therefore very likely to indicate severe risk aversion.

This also works the other way around. Assume an otherwise risk averse investor is responding to a risk profiling tool during a bull market. Their responses are then very likely to indicate a high level of risk tolerance. Also, the individual may not be completely honest with their responses. Therefore, reliance on risk profiling tools must be reduced. The outcomes of a risk profiling exercise must be interpreted more realistically. 

Assume a risk profiling tool rates risk capacity and tolerance between 0 (lowest) and 5 (highest). The overall risk profile score is taken to be the simple average of the scores of both metrics. An overall risk profile score of 0-2 indicates a conservative risk profile, 3-4 indicates a balanced risk profile and 4 onwards indicates an aggressive risk profile. Assume an individual has a risk capacity score of 4.5 and a risk tolerance score of 3.5.

This translates to a risk profile score of 4 (4.5 + 3.5/2). It indicates that the individual has an aggressive risk profile. This should see them having a significant equity allocation in their portfolios. But notice that their risk tolerance score is slightly lower than their risk capacity score. This means their behavioural preference for risk is lower. Therefore they may be better off with balanced allocations to equity and debt. 

Also, it is very hard to define the term 'aggressive risk profile'. The term is subjective in its very nature. But let us ignore this fact for the purpose of this discussion. To have a purely aggressive risk profile an individual must essentially be young (say below age 35), and also satisfy every single one of the conditions given below.

Most individuals would be able to satisfy some or most of these conditions. But no individual would practically satisfy every single one of these conditions. Therefore it is near impossible for one to have a purely aggressive risk profile. A more mature way to interpret risk profiles would be to say that all individuals start with a largely balanced risk profile. Each individual may then have a slight preference for aggression or prudence. 

Therefore to my common sense, the equity allocation in long term portfolios should not exceed 60%. This is independent of individual preferences for aggression or prudence. A long term portfolio with a 60:40 allocation to equity and debt would have something on offer for all individuals. Those with a preference for aggression would be happy that the majority of their portfolio is allocated to growth oriented assets. Those who prefer prudence would find comfort because almost half of their portfolio is allocated to stable, relatively less volatile assets. They would therefore be exposed to just as much risk as is required.

Asset Allocation Around And After Retirement

Asset allocation decisions during this phase focus on getting the right amount of equity exposure in the portfolio. A portfolio must have an optimal allocation to equity post retirement. It must not be too low to facilitate sufficient portfolio growth over the post retirement period. It must also not be too high. Otherwise, a sequence of poor returns may compromise the longevity of the retirement corpus. The equity allocation in a retirement portfolio must be a function of a few factors.

The first among these is the degree of dependence on the portfolio post retirement. The individual’s net worth at retirement also significantly impacts the equity allocation post retirement. The length of the post retirement period must also be taken into consideration.

In most cases, the individual would be wholly or heavily dependent on their portfolios post-retirement. Therefore, the room to take on risk in the retirement portfolio would be quite less. As a result, no more than 30% of the retirement corpus should be allocated to equity post retirement.

There may be a few cases where a higher equity allocation may be warranted. One such situation could be where the retiree has a high net worth multiple times the required retirement corpus. The disproportionately high net worth may mean that the individual would be able to take more risk in the portfolio post retirement. They can therefore afford to maintain a retirement portfolio with a higher equity allocation. The equity allocation can be met through large cap index funds. The debt allocation can be met through annuities and low risk categories of debt mutual funds. An illustrative asset allocation for such a case has been laid out in the graphic that follows.

Another situation could be where the individual has enough to retire early, say in their early to mid 40s. The post-retirement period would be around 40-45 years in such cases. This would be slightly longer than the post retirement period in the case of normal retirement at the age of, say, 55 onwards.

Therefore, the equity allocation post retirement may need to be slightly higher during the initial 10 to 15 years in retirement. This would facilitate portfolio growth over the more extended post retirement period. In later years, the equity allocation may be gradually reduced as required. An illustrative asset allocation for such a case has been laid out in the graphic that follows.

What Next?

At this point our goals are defined, risks are provided for and an investment framework is in place. The natural next step is to fill out the set framework. This involves selecting the ideal investment avenues within each asset class in the portfolio. And investment selection would be the topic of discussion in the fourth and final part of this series.