70% Equity: 30% Debt - in the long term, if rebalanced back to original allocation every year (for +/- 5% deviation), provides a return close to 100% Equity.
So, go beyond 70% equity allocation only if - time frame >15 years + you have successfully handled 1-2 bear markets
Now onto our simple framework
TTT Framework
1. Time Frame 2. Tolerance to Declines 3. Tradeoff
1.Time Frame
Higher time frames can accommodate higher equity allocation
2. Tolerance to Declines
English Translation: What extent of temporary portfolio declines will you be ok with?
There are 2 types of temporary declines: 1. Normal: 95% odds 2. Unusual: Can't be qualified - will happen but no idea when - worst case outcomes
Normal Temporary Declines:
95% of the times the 6-month range of return outcomes for Indian Equities were between -27% to 61%.
Similar takeaways from Sensex intra-year declines for the last 40+ years
10-20% temporary declines in equities are as common as your birthday!
Putting normal 6 month return expectations into our asset allocation
Unusual Temporary Declines:
But sh*t happens!
30-60% falls while not frequent do happen roughly once every 7-10 years
Adding that to our short term temporary decline expectations:
Convert % into values based on your portfolio size.
Eg for 1 cr portfolio.
Choose your poison based on the asset allocation you can live with...
3. Tradeoff between risk and returns
Add in the return expectations (a rough sensible guess)
Assuming equity returns at 12% and debt returns at 6%...
Convert % into real nos
Appreciate the tradeoff.
If you have chosen Risk 3, the drop from Risk 4 to Risk 3 will cost us around Rs 28 lakhs in the future.
But that’s fine. This is the cost for reducing our anxiety and sleeping well.
While moving back to Risk 4 might seem tempting, the key is that you need to really introspect if you will be able to stay through the journey to enjoy the outcome.
Based on all the above, pick your asset allocation knowing both the likely short term pain and long term gain.
Summing it up:
TTT Framework
1. Time Frame
* Higher the time frame higher the equity allocation
* Not more than 70% Equity Allocation
2. Tolerance for Declines
* Expected Normal Declines
* Expected Worst Case Declines
* Check in actual values and not percentages
* Adjust chosen asset allocation based on past behavior
3. Tradeoff between risk and returns
* Understand the long term trade off in returns
Own your choice and rebalance every year for +/-5% deviation.
If you like to read about this in detail check here
1) When we start with Asset Allocation, actually we are already underweight equities (less than 100%) based on the % of temporary falls we can tolerate.
2) This default underweight does not require identifying 'when' the market will crash. But should be based on expectation (derived from history) i.e 10-20% temporary decline almost every year and 50-60% temporary fall once every 7-10 years in equities.
3) If markets happen to crash suddenly, our default underweight position (called asset allocation) will reduce the impact and debt allocation can be used to buy at lower levels
A superb recent performance may sometimes mask dangerous risk-taking. A dismal recent performance may sometimes mask a solid investment process and good long term track record. Differentiating both is unfortunately more art than science.
A thread on how to address this...
1) Consider full market cycle performance from peak to peak or bottom to bottom.
2) Check how did the performance occur - huge sector calls, concentration, mid & small cap exposure etc
3) Check downside capture ratio and declines vs benchmark in all major falls
4) Do you understand the process?
5) Do you have a rough quantitative/qualitative check for the process by looking at portfolios?
6) Will you be able to tell if the process is followed especially when a fund is underperforming?
1) What took three years and seven months in the Great Depression took one year and six months in 2008, and only one month in the current crisis!
2) In the Great Depression, it took 3 years 7 months from Black Thursday before President Roosevelt broke the peg to gold, allowing the Fed to print enough to stop the free fall in equities and the economy, and the reflation continued for 4 more years before the next downturn.