Well known studies by Brinson et.al. (1986,1991) concluded that “More than 90 percent of the variation in a portfolio s performance over time is due to its asset allocation”. The studies further assert “… investment policy dominates investment strategy(market timing and security selection).” These findings have become the bedrock of financial planning discourses and have their fans and critics alike.
Here are golden rules of asset allocation
Rules over Views:
Views are beliefs formed over time and involve predictions about markets. They are based on assumptions about future outcomes. These views differ depending on one’s ‘conditioning’ and may or may not hold true. However, an asset allocation plan based on ‘rules’ or some pre-determined scientific formula which uses actual parameters, is likely to triumph over views and market outlooks.
Understanding Behavioural biases: Investing is more behaviour than math:
Investment decisions are driven by biases and not necessarily facts. Empirical theories assumed that investors were rational beings and made economically sound decisions based on data. However psychologists who studied investment behaviour, realised that investors make decisions based on biases and emotions. These decisions may or may not be prudent for their financial health. Hence a formula driven asset allocation eliminates the emotions and human biases out of the investing framework.
Low Correlation among Asset classes is important:
Correlation means how two variables move together. If both variables rise or go down together, they are said to be positively correlated. If one variable does something and the other does the exact opposite, they are inversely correlated. And if there is no relation between the movements of two, they are low or not correlated.
Investing in asset classes which have low correlation or have negative correlation to each other spreads the risk. Over a long term period, such a portfolio will deliver better risk-adjusted returns.
Discipline – To Rebalance and alter weights systematically:
Bulk of the effort in choosing the right investment is centered on the ‘best returns’ generating instrument and very little effort directed towards risk, time horizon and goals. Since it is difficult to predict which asset class will perform and when – Asset Allocation is the best way to take care of this uncertainty. Asset Allocation must never be at the mercy of ‘last one year returns’. With regular rebalancing across asset classes one can maximize the benefits of asset allocation.
Risk Tolerance and not just Age:
Asset allocation based on age uses a thumb rule: 100 years – Current Age = % in Equity/Risk Assets. Well, this is very first-level thinking. It is based on the assumption that younger investors have longer time to make money and hence must allocate higher portion of their investable surplus to high risk assets. Asset allocation should be based on overall risk tolerance rather than age alone. Risk tolerance is the ability of an investor to tolerate uncertainty of returns. Risk tolerance is a combination of various factors such as one’s income, liabilities, number of dependents, financial goals, need for cash flows, savings, and age.
Taxation:
Taxes are happy outcomes. In the obsession to avoid taxes – one may end up taking undue risks. Secondly investments done purely for avoidance of taxes may lead to sub-optimal outcomes. Optimising taxes rather than avoiding them should be the goal.
Investors would do well not to trivialise asset allocation to a percentage of equity/fixed income allocation. An informed discussion with your financial advisor, Asset Allocation, financial goals can be a good first step. These Golden rules can serve as a guideline towards building resilient investment portfolios with the ultimate aim of helping investors achieve their financial goals.
Originally published in Money Control on 29th September, 2020
FAQs
The “100-minus-age” rule is a widely recognized rule of thumb in personal finance used to establish asset allocation, the practice of distributing your investment portfolio among various asset classes such as stocks, bonds, and cash.
What is the golden rule of the portfolio? ›
Rule No.
1 is never lose money. Rule No. 2 is never forget Rule No. 1.” The Oracle of Omaha's advice stresses the importance of avoiding loss in your portfolio.
What are the 5 golden rules of investing? ›
The golden rules of investing
- If you can't afford to invest yet, don't. It's true that starting to invest early can give your investments more time to grow over the long term. ...
- Set your investment expectations. ...
- Understand your investment. ...
- Diversify. ...
- Take a long-term view. ...
- Keep on top of your investments.
The 5% rule says as an investor, you should not invest more than 5% of your total portfolio in any one option alone. This simple technique will ensure you have a balanced portfolio.
What is the golden rule allocation? ›
The golden rule of government spending is a fiscal policy that a government should borrow only to invest, not to fund current spending. In other words, the government should borrow money only to make investments that will produce long-term benefits for the future.
What is the golden rule the best rule? ›
The “Golden Rule”—“Love your neighbor as yourself”—is doubtless the most widely known and affirmed ethical principle worldwide. At the same time, it has its serious, quasi-serious, and jocund critics.
What are the 7 rules of investing? ›
Schwab's 7 Investing Principles
- Establish a plan Current Section,
- Start saving today.
- Diversify your portfolio.
- Minimize fees.
- Protect against loss.
- Rebalance regularly.
- Ignore the noise.
The Golden Rule is the principle of treating others as one would want to be treated by them. It is sometimes called an ethics of reciprocity, meaning that you should reciprocate to others how you would like them to treat you (not necessarily how they actually treat you).
What is the Golden Rule gold rules? ›
The famous adage about the 'golden rule' states that “whoever holds the gold makes the rules.” In advertising that means of course that the advertiser should make all the rules.
What is the golden rule of saving and investment? ›
Saving Equals Profit
This parallelism implies that saving per capita equals profit per capita. Furthermore, consumption per capita equals the wage per capita. So to invest all profit and to consume all wages leads to the golden-rule of saving in the long-run steady state.
The three golden rules of accounting are (1) debit all expenses and losses, credit all incomes and gains, (2) debit the receiver, credit the giver, and (3) debit what comes in, credit what goes out. These rules are the basis of double-entry accounting, first attributed to Luca Pacioli.
What are the 5 golden rules of be there? ›
The Five Golden Rules:
Say What You See. Show You Care. Hear Them Out. Know Your Role.
What is the 10 5 3 rule of investment? ›
The 10-5-3 rule is a simple rule of thumb in the world of investment that suggests average annual returns on different asset classes: stocks, bonds, and cash. According to this rule, stocks can potentially return 10% annually, bonds 5%, and cash 3%.
What is the 80 20 rule investment portfolio? ›
In investing, the 80-20 rule generally holds that 20% of the holdings in a portfolio are responsible for 80% of the portfolio's growth. On the flip side, 20% of a portfolio's holdings could be responsible for 80% of its losses.
What is the 60 20 20 rule for portfolios? ›
Introducing the 60/20/20 Portfolio
The 60/20/20 takes half of the 40% that was originally dedicated to bonds and allocates it to an equal weighted mix of CTA, EQLS and QIS. The resulting portfolio is comprised of: 60% Stocks. 20% Bonds.
What is the 12 20 80 asset allocation rule? ›
Set aside 12 months of your expenses in liquid fund to take care of emergencies. Invest 20% of your investable surplus into gold, that generally has an inverse correlation with equity. Allocate the balance 80% of your investable surplus in a diversified equity portfolio.
What is the difference between 70 30 and 80 20 asset allocation? ›
The main difference between the 70/30 and 80/20 asset allocation models is how much risk you're taking. With an 80/20 allocation, you're devoting a larger share of your money to stocks, which can mean greater exposure to stock market volatility.
What 3 things determine your asset allocation? ›
Choosing the allocation that's right for you
- Your goals—both short- and long-term.
- The number of years you have to invest.
- Your tolerance for risk.
Do you know the Rule of 72? It's an easy way to calculate just how long it's going to take for your money to double. Just take the number 72 and divide it by the interest rate you hope to earn. That number gives you the approximate number of years it will take for your investment to double.
