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The other helmet

The fixed-income side of your asset allocation is relatively easy to reason about. As one would expect, equity is harder

The other helmet

Last week, I wrote about the necessity of having a substantial fixed income allocation for every investor. Using a Jerry Seinfeld comedy clip as an illustration, I'd pointed out that having a small fixed income allocation (five or ten percent) gave an illusion of safety while actually not delivering a useful amount of safety in the event of a mishap. Rather, in the words of Jerry Seinfeld, "What exactly is the role of the helmet in skydiving?"

My point was that one, everyone should have some fixed-income allocation and two, there's no point in getting very complicated about calculating it. Depending on your general attitude to risk and safety in investing, you can choose either 1/3rd, or 1/2 or 2/3rd in fixed income and that's enough. Don't sweat the decimal places. In fact, do not even sweat the digit before the decimal, it doesn't really matter.

So this week, let's progress to the next stage, of taking a closer look at the equity part of the story. A logical corollary of the above ratios is that you would also have either 1/3rd, 1/2 or 2/3rd of your investments in equity. However, in a seeming contradiction to the basic principle, I don't think there's much point in being dogmatic about it when one starts investing at a young age and the amounts accumulated are not very meaningful in your financial situation.

Nowadays, many younger people dip their toes into equity investments by starting a small SIP, typically in an ELSS fund, soon after they start working. It takes some years to build up this asset into something that matters financially. At this stage, the big payoff is the tax-saving, which gets delivered upfront anyway. There's no point obsessing about a fixed-income allocation and start looking for another fund to put 1/3rd into. Zero is perfectly good as an equity allocation right in the beginning!

Essentially, you should progress to higher and higher stages of a fixed income allocation based on your judgement of how safe or how risky you feel. The question you must be asking yourself, the risk of what? How much will the equity markets fall? That's an impossible question to answer, obviously but I can offer a thumb rule. Once every decade, be prepared for the equity part becoming half in value and then slowly recovering over the next 2-3 years.

Imagine this happening to the equity part of your asset base. Can you take that much of a transient loss? If the answer is no, then drop to the next lower level of equity exposure. As your life, career and investments progress, one would expect the fixed income part to increase. There are no hard and fast rules. I know people who are happy with 50 percent equity even after retirement. They are not earning any more but after a lifetime of experience with equity, they are confident of what they are doing. They know that the value flows away and then it comes back stronger. At the other end of the spectrum, there are much younger people who just can't bear the thought of losing more than a little bit of the value that has already been accumulated in their portfolios.

At the end of the day, it's a question of judging your own psychology and getting a feel for what makes you merely uncomfortable and what makes you panic. Financial advisors like to peddle formulae and calculators that will come up with some precise ratio as the right asset allocation. That makes no sense to me. The biggest input is your own state of mind. There's no way to quantify that and put it into a calculator. Knowing yourself is the best input to your investment plans.