How investors willing to take more risk should plan asset allocation

One of the basic premises of financial planning is that your asset allocation must be based on your risk capacity and not risk appetite. These are two different things. When we draw up the risk profile of an individual, it is about assessing risk capacity or the risk that can be assumed.

Risk appetite is a lot more psychological. For example, a man at the age of 45 with three loans and a family to support may have the risk appetite of a sailor, but his risk capacity will not be that high. When we talk of risk takers in financial planning, we are talking about investors with a higher capacity for risk.

Risk profile and risk-return trade-off

Asset allocation has two key components at the build-up stage. Risk profile as stated above is the capacity for taking risk. Risk profile is based on factors like your appetite for risk, income levels, assets and liabilities, goals, investment time frame etc. Most of these factors keep changing and hence your risk profile also keeps changing. What do we mean by a risk return trade-off? The basic rule in financial planning is that higher returns entail higher risk. You can put all your money in a liquid fund and hope to multiply your money in five years. If you look at a typical liquid fund returns in India in post-tax terms, it is just about 4%. That means; it would take you 18 years to double your corpus. That is hardly a smart way to do it. When you have a higher risk capacity, it makes sense to take on higher risk because that is the only way you will create wealth. Similarly, you cannot take risks that you cannot afford because that would mean endangering your financial position.

Asset allocation using the risk based model

Asset allocation varies for different classes of investors with different risk capacities. While the growth portfolio (growth assets of 90% and 10% of income assets) is meant for an investor with high risk capacity, the conservative portfolio (income assets of 75% and 25% of growth assets) is for a person with very low risk capacity. The balanced portfolio is the most common allocation where investors focus 60% on growth assets and 40% on income assets.

The growth investor is just starting out on his career, has limited responsibilities and has built assets of his own. He needs to generate wealth over the long term so he has to make money work hard. Once the contingency liquid fund is created, he can surely look at a 90:10 mix in favour of equities and then gradually keep shifting towards a more conservative profile in a progressive manner.

Designing asset allocation for a high risk taker

How the portfolio should be designed for an investor with a relatively higher risk capacity. Let us look at the asset allocation in two stages.

In the above allocation, we have first broken up the overall allocation into Growth and Fixed Income and then further broken up the Growth Allocation. Here is how we have gone about it.

Out of the total growth allocation, we shall remain 50% in diversified large-cap equities. They are the most promising wealth creators over the longer period with manageable risk. There is a 20% allocation to passive index products like index funds and index Exchange Traded Funds. This would be a mix of domestic and global ETFs and will include equity indices, global indices and gold. There is another 20% allocation we have made to equity opportunities that may be more time bound. This would include sectoral funds, thematic funds, mid cap funds, dividend yield funds etc. The tenure of such allocations will be largely dependent on the tenure of the opportunity. Lastly, we have set aside a small allocation to alternatives which are emerging. Structures and REITS are new products but they can give proxy allocations to real estate and derivatives respectively

Risks to this allocation strategy

Having understood the strategy for the high risk investor, one also needs to realise the stakes involved. For starters, this is a portfolio that is largely linked to the fortunes of the stock markets. Nearly 70-80% of the growth allocation is likely to be in equities and that makes it extremely vulnerable to macros like inflation, interest rates, growth, fiscal deficit etc. The exposure to global ETFs opens up the portfolio to exchange rate risk although the allocation is quite small. Similarly, the opportunity allocation is normally quite vulnerable to government policy. Investors need to remember that while this allocation comes with a better upside potential in the long term, it also comes with a bigger downside risk in the short term. That is the core of the trade-off for risk taking investors.

The writer is chief revenue officer, Angel Broking. The opoinion is for reference only