You should carefully decide on how much to invest in equity to achieve your investment objective, given the high volatility in the stock market since 2008. In this article, we offer a simple, yet useful method to design your asset allocation strategy- the process of deciding what proportion of your total investments should be in equity and other asset classes.
Suppose your goal is to buy a house six years hence. Your ability to achieve the goal is determined by how much you invest in equity. Why?
If you invest too much in equity, you will achieve your goal comfortably if the stock market does well. But you will fail to buy the house if the market declines, as your investment would have lost significant value!
The flip side has its issues too. If you are too conservative and invest primarily in bank fixed deposits, you might get back your nominal capital but will certainly fail to achieve your target!
The reason is that interest on bank deposits is typically lower than the return required on your investments!
Your task then is to balance your investments between stocks and bonds in such a way that you achieve your investment objective with minimum risk. That is why asset allocation becomes important in your quest to achieve your goal.
Investment advisers typically use optimisation models to design your asset allocation. Suffice it to know that these models require you to input variables such as how much risk you are willing to assume and the relationship between stocks and bonds during your investment horizon.
You, of course, realise that it is not easy to forecast the correlation (relationship) and other such inputs. What then should be your preferred course of action?
Suppose Rs 2 crore will buy you a 1,500 sq ft dream house six years hence.
You may decide to buy at least 1,000 sq ft in the event you fail to accumulate money to buy your dream house. You, therefore, require at least Rs 1.33 crore in 6 years or Rs 33.33 lakh assuming you make 25 per cent down payment.
Let us call this your threshold value. You should invest your initial capital and regular contributions in bank deposits such that the accumulated amount meets the down payment of Rs 33.33 lakh in six years. You should prefer bank deposits because there is no risk of erosion of nominal capital, assuming the bank honours its commitment to you!
At 9 per cent interest, you will have to contribute Rs 34,750 every month to accumulate Rs 33.33 lakh in 6 years. And how much should you invest in equity?
You need Rs 50 lakh, 25 per cent down payment on your dream house of Rs 2 crore. But you have already allocated Rs 33.33 lakh towards bank deposits. You now have to accumulate Rs 16.67 lakh to bridge the gap. Assuming 12 per cent annual return on equity, you have to invest Rs 15,750 every month in stocks for six years.
So, your total monthly investment is Rs 50,750; your asset allocation is 68 per cent bonds and 32 per cent equity.
The threshold value method is a simple way to design your asset allocation.
Invest in bank deposits to meet the threshold value and buy equity for the rest. But what if you cannot contribute the required amount to meet the threshold value? Rather than take a higher risk to achieve your objective, you should scale down the investment value or extend your investment horizon.
Your objective is to achieve the threshold value with low chance of failing.
What is the point in having a risky portfolio that either helps you achieve your desired objective (Rs 2 crore) or just fails to get you anywhere?