Asset Allocation — How the Split Gets Decided

Every portfolio is doing two jobs at once and they pull in opposite directions.

One part is meant to grow over long periods, which requires accepting that it will fall sometimes, occasionally by a lot. The other part is meant to be there when you need it, at a value that does not depend on what markets did last month. Equity does the first job and cannot do the second. Deposits and low-risk categories do the second and are not built for the first.

There is a middle ground for money that is neither long-horizon nor needed next week, and categories such as arbitrage funds tend to be used there. That is a narrow slot rather than a third pillar.

Asset allocation is simply deciding how much of your money is doing each job. Once that is settled, the choice of scheme within each part is a smaller decision than most people treat it as, which our page on how to choose a mutual fund sets out.

The useful way to arrive at a split is to start from what the money is for and when it is needed, because those are facts about your life rather than guesses about markets.

Money you may need within about three years belongs outside equity, whatever the current conditions look like. Money for something eight or fifteen years away can take the volatility, because there is time for a bad stretch to pass before the date arrives. Everything else sits between those two, and our pages on child education and retirement work through goals of that kind.

Doing it this way means the split is derived rather than chosen. Add up what each goal needs and by when, and the equity share falls out of the arithmetic instead of out of a view about where markets are heading.

Almost every household we sit with underestimates one side of their own balance.

On the stable side sits the provident fund balance, deposits, small savings balances and any low-risk category holding. People routinely leave the provident fund out, and it is often the single largest stable holding they have. On the growth side sits every equity scheme, any shares held directly, the equity portion of a hybrid scheme, and under NPS the part invested in market-linked funds whether or not the subscriber picked that.

Add both sides up honestly once. Households that assumed they were heavily in equity often find the opposite, and households that felt safe sometimes find their split drifted a long way while they were not looking. Our page on portfolio rebalancing deals with what to do about drift once you can see it.

Dates give you a defensible split. Whether you can live with it is a separate question and it is not a soft one.

A portfolio built entirely on horizon logic can still be abandoned in the middle of a fall, and an allocation abandoned halfway through is worse than a more modest one held all the way. The only honest evidence anybody has here is what they actually did the last time something they owned went down, which is why we ask that rather than asking how somebody describes their risk appetite.

If the honest answer is that you stopped, sold or lost sleep, the sensible response is a smaller equity share held with conviction rather than a larger one held nervously. Our guide on what a red number actually means covers the moment this gets tested.

An allocation is not a permanent setting, but the reasons to change it are narrower than people assume.

The legitimate reason is that a date has come closer. A goal fourteen years away and the same goal three years away are different problems, and the equity share for that money should have come down considerably in between. Doing that gradually, over the last few years before the date, is the part most people skip and then regret if the timing is unkind.

Income changing, a household adding a dependant, or a large obligation appearing are also legitimate reasons. A market forecast is not, and neither is a strong recent run in one category, which is exactly when the pull to change is hardest to resist.

You will find formulas that set the equity share from age alone. They are a starting point and their weakness is that they ignore everything specific about you.

Two people of the same age can have entirely different sensible splits: one with a stable income, no dependants and a house already paid for, the other with an irregular income, three dependants and a loan running. Age is a proxy for horizon, and where the proxy and the real horizon disagree, the real one wins. Our page on SIP for business owners deals with the irregular-income version of this.

Use whatever formula you like as a sanity check on a number you derived from your own dates, not as the source of the number. If you want to work through your own split with somebody who will look at what you already hold before suggesting anything, get in touch.