An alternate way of looking at asset allocation.
A friend was somewhat distressed with his father’s portfolio. He believed his father, who is seventy five, was taking too much risk at his age, by having over 50% of his money in equity. This triggered an interesting discussion.
For the uninitiated, the general rule of thumb for constructing a portfolio is 100 minus Age. In other words, if someone is 70 years old, then 30% (100–70) should be in equity, the balance 70% in debt, a safer asset class.
There are two main reasons for this. As you grow older,
your time horizon to be able to ride out market dips shortens.
your dependence on a stable cash flow increases.
It’s a very sound rule of thumb, but that’s just what it is — a rule of thumb or a broad generalisation which merely provides a starting point to planning one’s portfolio.
So how else should one decide?
Here’s what I did for my mother. It’s simplistic, but that’s how I prefer to keep things. Better, more scientific, approaches may very well exist. We would love to hear from you.
Nevertheless, here goes.
- I sat down with my mother and helped her calculate her monthly expenses. We did this a few times, just to be sure we covered everything. When we arrived at a consensus number, we multiplied it by 12 to determine her annual expenses.
- We then added to this certain heads of expenses which are not incurred monthly. Some come up once or twice a year — like holidays and insurance premiums. Some are often unplanned and unexpected — like replacing an appliance. We now had a better sense of her annual expenses. This is how much she needed every year. Let’s call it Rs. 100.
Coming to what she had.
- My mother earned a government pension and it amounted to (in comparative terms) Rs. 45 a year. As a result, her investments needed to generate Rs. 55 as cash flow every year.
- We first began by solving for cash flow. The math we had to crack was: how much money needs to be kept aside to earn Rs. 55 every year. For certain. No ifs and buts.
- We assumed a 6% return from relatively boring and safe debt products. And back-calculated the amount required to earn Rs. 55. We now had the required allocation for debt. We increased this amount further to account for
a) Inflation — cash flow requirement from investments would be 55 in year 1, but then increase every subsequent year owing to inflation. We planned for 5 years.
b) Buffers — taxes, unexpected expenses, extra liquidity.
4. With adequate buffers in place, we now knew how much money should go in debt investments. The balance was free to be invested in equity.
It was surprising to see that this approach resulted in an equity allocation of 60%. Had one relied entirely on the rule of thumb, one would have invested just 35% in equity. She is around sixty-five.
Her equity allocation was almost 2x of what it would have otherwise been.
And she’s achieved that without taking any stress on cash flow.
As an aside, the buffers we created, have allowed her to rebalance and add more money to equity during this fall. We haven’t exhausted the entire buffer though. We’re secretly hoping for a further fall.
How have you planned your portfolio? If you’ve followed a different approach, we would love to hear about it.
This article contains the opinion of the authors and not financial advice. If you like stuff like this, join our Telegram channel.
