Having a balanced portfolio between debt and equity is essential. That’s because each asset class has a different risk-return profile and helps you meet different financial goals over different investment horizons. If your equity allocation stands at 95%, it may be prudent to put more money in debt funds instruments. However, to figure out the exact percentage of allocation, you will have to consider a few things.
- Understanding the risk of equity investments
Equity instruments such as equity mutual funds and stocks are high risk because they are market-linked. This means that your returns are not guaranteed and are impacted by the volatility in the stock market. Anything can send the prices of stocks down or up, be it inflation, a pandemic, news of a change in the company’s CEO, change in government regulations concerning the industry, supply chain issues, geopolitical unrest, etc. However, this volatility is a double-edged sword. While it brings with it risk, it also brings with it the possibility of higher returns.
- What is your risk appetite?
Your risk appetite tells you how much of your portfolio you can afford to put towards equity investments. Your risk appetite is the amount of risk you are willing and able to bear. This primarily depends on your age, income, existing debt, number of dependents, and personality type. Having equity allocation as high as 95% can be alright for someone who is just starting out in their career, has no dependents to take care of or debt to repay, has little expenses, and has decades of income-earning years ahead of them. That’s because having equity allocation at 95% is a highly aggressive investment strategy and carries great risk.
A more moderate and popular approach followed by investors to figure out what their equity and debt asset allocation should be is to minus age from 100. For instance, if you are 30 years old, your equity allocation should be 70% and debt should be 30%. It is important, however, to look at this in a more nuanced way and consider your personal financial situation as well.
- The role of your financial goals
When deciding your asset allocation, along with your risk appetite, your financial goals serve as a guidepost. If a lot of your goals are long term, say over seven to ten years away, then you can have a higher equity allocation. That’s because while in the short-term equity investments are risky, over the long term, the fluctuations owing to market volatility are often ironed out. A longer time horizon also gives your equity investments the chance to grow and build wealth.
On the other hand, if you have short-term or medium-term goals, then you may want to consider allocating more money to debt schemes. That’s because debt investments are not market-linked and hence the risk of capital loss is minimal to zero depending on the type of debt instrument. Debt instruments with a high credit rating of AAA carry essentially no credit risk. Hence, when you want to preserve your capital and earn some returns on it in the short term before you need to use your funds for a financial goal, debt investments are ideal.
This is why it is important to be aware of your short-term, medium-term, and long-term goals and then undertake goal-based investing. If you primarily have long-term goals and a high-risk appetite, you can have a higher equity allocation.
When you are initially building your portfolio, figuring out things like your risk appetite and how to undertake goal-based investing through products like mutual funds may seem a little tricky. Hence, you can consider consulting a financial planner to get you started. It’s also essential to note that as time goes by, you may have to review and rebalance your portfolio and change the equity and debt asset allocation as your goals and financial situation changes.