Couple of weeks back, i wrote about how do i select a fund for my portfolio. That has got quite a few review/ feedback, though few people also requested to share my approach on asset allocation. Today I am trying to put together my thought process, The real process is more or less meet these steps in principal for long term goals (5yrs & beyond). You might find this tedious but this is typically a once in few years exercise and If you find it tedious than stick with typical simplified thumb rules (I will summarize it in the end).

I typically segregate my portfolio in two sections, first which holds risky assets like equity & gold and second which has debt investments.

Step 1: The selection of equity funds was covered in detail in the last article (Please read: Link). I analyse the list of potential funds with there risk & return profile and then pick the fund which has a better return per unit of risk. This process can also be called as formation of Efficient Frontier. This is the line of selected funds in a manner that each fund has the best return for the same unit of risk. The funds which are not on the Efficient Frontier like ICICI Pru Bluechip or SBI Large & Mid cap etc are not considered. Based on my risk profile, I pick one fund from the funds on this frontier line.

Efficient Frontier

Step 2: There is an advantage of adding gold with equity funds which does reduces the volatility of the portfolio given the -ve correlation between gold and equity.  This was reflected in the earlier articles Gold: to buy or not to buy! & Modern Portfolio Theory I personally like to keep (10% – 20%) of risky asset portfolio in gold depending on the valuation cycle of equities. You can see from the below chart that portfolio 3 outperforms most of the time with lowest risk among portfolios. I personally prefer the Portfolio 2 which has similar return profile but slightly higher risk. The main reason to do so is that a good multi-cap fund mostly will have 60-30-10 split between Large cap, Mid-cap and Small cap. Instead of me looking for 3 different funds.

Portfolio 2 = Gold 10%, Large cap 54%, Midcap 27% and Small Cap 9%

Gold & Equity

Step 3: The last step is to decide the split between the risky assets and risk free assets. Risk free assets are your fixed deposits, EPF, PPF etc where the returns are fixed and not highly volatile. Debt funds does carry various risks like counter party risk, interest rate risk etc. (Read: How to build your debt portfolio.) The mix of debt investments is to reduce risk in your investments. Let’s see the possible range of returns i expect at the various portfolio mix.

Portfolio Returns_V1

So even if you are defensive investor, you should keep at least 10% investment in Eq+Gold and if you are a super aggressive investor, still i would suggest to keep 20% of your investments in the Debt instruments. I personally hop between three asset allocations 80% Debt/ 50% debt or 30% debt and rest in equity + gold based on Valuation Index. I have been in the 80-20 split for last 2 years and now moving towards 50-50 split, The last 10yrs CAGR of the portfolio is still >10% including the double digit returns in FY 19-20 even after the recent drop in equity markets.

Now, I can understand that doing all these things together can be too complicated for a simple investor. What is the simplified approach? A portfolio like below is widely suggested and it has its merit of being moderate in approach as well as can be suggested to a wider population. Follow a 60 : 40 Portfolio and keep re-balancing it half yearly, you will outperform most of the portfolios.

Asset Allocation

Please note that most of these analysis are on the past returns/ historical data so there is no guarantee of similar return profile in future. As i mentioned, I personally follow Dynamic Asset allocation mostly for the risk management and engagement in managing my portfolio. let me know if this was helpful, looking forward to your comments/ feedback. 

Happy Investing!