How much would you allocate to bonds ?
In this last post on Debt investments, I would cover allocation or in Simple words – How much of the portfolio should be in invested in debt instruments
Situation 1 – I know I need to double my portfolio in 6 years after paying taxes so that I can meet my personal needs
Here you know the target return on investment, i.e. 12% pre-tax on a compounded basis to double your portfolios in 6 years. Now first one has to understand on an average historical basis how much debt and equity has returned. In India if look at last ten years data
Debt has given approximately 9% pre-tax return that equates to post tax return of 7.2% ( Assuming you pay 20% income tax)
Equity has given approximately 14% post tax return
Based on above one has to invest 70% in equity and 30% in debt to achieve their goal of attaining 12% pre-tax compounding return
But should you get obsessed with past performance? Understand past is not a guarantee of future performance, however one has to start somewhere and the best way is to learn from history.
Situation 2 – I am not sure about my future needs however I don’t want to over or under invest in any asset class hence I need to maintain a constant ratio for my debt and equity investments
This is the case with many of us, the idea is to maintain a balance and a constant ratio between our debt and equity exposure. At outset you will decide that a 50:50 or 70:30 or 80:20 or whatever ratio of debt and equity suits you. Also you will decide a fixed time period after which you will re balance portfolio it could be say every six months or three months to bring back the portfolio to its original exposure of 50:50, let’s look how this is going to play out if you started with 100 rupees
a. After six months Equity has become 70 and debt has become 40
Buy debt for 15 sell equity for 15, the portfolio rebalances to 50:50
b. After six months debt has remained 5o, however equity has become 30
Invest 20 more in equity to rebalances to 50:50
By investing this way you will naturally buy when market is low and sell when market is high. There are no hard-and-fast rules for timing portfolio rebalancing under this asset allocation method. However, a common rule of thumb is that the portfolio should be rebalanced to its original mix when any given asset class moves more than 5% from its original value at the time of assessment
Situation 3 – I am not sure about my future needs however is there a thumb to divide my equity and debt exposure
All thumb rules fails to take into account investor circumstances but some popular ones are
60/40 rule i.e. invest 60% in equity and 40% in debt
Another often quoted one is 100-age rule, so if you are 30, you invest 70% in equity and 30% in debt.
I am no fan of this thumb rules but the age rule has lived on for many years, therefore something must be right by investing in this manner
Lastly I would like to cover some emotional biases that are associated with allocations and we as investors should avoid them
a. Loss aversion – You have got in a situation where the current allocation has backfired, In most of such situations the investors turns into a gambler and start taking undue risks. We should avoid getting into this gambler’s fallacy.
Remember most of the times ability to generate market beating returns is not only depends upon finding superior instruments but also on our ability to stay disciplined and remain unemotional.
b. Regret – Holding onto losers, if you have made a wrong allocation and you know it is wrong make peace with yourself accept the mistake and move on. There is no point in holding onto losers
The above allocation principles can be applied to both equity and debt.
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