How much to allocate to equities – a million dollar question!


Banyan Tree Advisors

December 22, 2014

One of the most common questions asked by people we meet is: ‘What should be my allocation to equities?’ While this is best answered with the help of a certified financial planner, the most common theory is that one’s equity allocation should be x% of their total net worth (excluding the house that one stays in) where x is 100 minus the current age of the individual. So if an individual is aged 40 years, the allocation to equities should be 100-40 = 60%. There are others who believe that the allocation should be dynamically altered depending on the attractiveness of the asset class.

We believe the answer to this question is not as straightforward, but nevertheless can be easily arrived at in a few steps. Let us first look at what are the objectives of any investor while investing and also consider some background on different asset classes.

The objectives for any investor would be protection of capital and maintaining (at worst) and ideally, improving the purchasing power of the rupee given that inflation eats into our savings each passing day and year. Given that savings is essentially deferment of consumption, the goal of investment would be to meet future needs that come during different life stages of the individual and his/her family.

Now let us look at what the returns over a cycle (typically 7-8 years) that different asset classes have generated in the past. It is important to note that past returns may not be indicative of future. However, it does give us a sense of the trend and can help make some assumptions.

Bank FD – 8-9% (pre-tax)
Real estate – 11-13% (pre-tax) *
Equities (Sensex/Nifty) 13-14% **

** returns on real estate vary significantly across locations and cities. However, on a longer term (10-15 years), returns hover around this range
** equity returns for long-term investor tend to be tax free as dividends are tax free and long term (holding > 1 year) capital gains on listed securities currently attract zero tax.

Over a period of 5-7 years, the returns in equities (even if one were to just invest in an index fund) mirror the nominal rate of GDP in India. What we define as a cycle is low to low or high to high of the index over time. So if India’s real GDP averages 6-7% and inflation is about 6-7%, we get a nominal GDP growth rate of 13-14% and that is typically what a long term investor in equities in an index fund has made.

So clearly, the dice is stacked in favour of a long term equity investor – where one gets to ride an asset class which grows faster than most asset classes, offers high liquidity and enjoys an extremely favourable tax treatment. If only, one can ignore and/or digest the volatility in the equity markets and stay invested with a long term perspective, the outcome can be extremely rewarding.

Of course, one needs to wisely select companies which are high quality businesses and buy them at reasonable valuations.

The other fact that one needs to keep in mind is the power of compounding. Have a look at the table below:

Annual Return ->Investment Horizon 6% 10% 15% 20% 25%
5 Years 134 161 201 249 305
10 Years 179 259 405 619 931
20 Years 321 673 1637 3834 8674

Rs. 100 invested for 20 years at 6% (typical post tax FD rate) will be worth 321, at 10% would be worth 673 at 15% (historic equity returns in India) would grow to 1637 and at 20% would be a phenomenal 3,834!

Now coming back to the original question on asset allocation, we believe that one’s allocation to equities should depend on the following:

  • First and foremost, anyone investing in equities should do that with a strategic, long term horizon – minimum 4-5 years, ideally longer. So, after keeping sufficient in reserve for liquidity requirements which may arise from time to time, one can allocate that portion of one’s funds to equities that one does not foresee a need for, for at least 4-5 years. For a middle-aged person, who has a residual life expectancy of 40-50 years, we need to plan finances for a fairly long term. As Indians, the typical thought process is that of leaving ‘something’ behind for future generations. As such, one can easily take a 10, 20 or 30+ year view. Most investors tend to invest in FDs/PPF and other fixed income investments with a long term horizon whereas most of these fixed income avenues are sure ways to allow inflation to eat into the savings!
  • Second and equally important, how comfortable one is with the equity exposure. If one is not that comfortable, it would be wise to start off with a smaller allocation and increase it as one gets more and more comfortable with equities as an asset class

Therefore, with the 100 minus your age theory, does it make sense for a 35 year old to put 65% of her assets in equities, if she is going to need the money in the next 2-3 years for say, buying a house or if she has never invested in equities and is not comfortable with it? Conversely, consider a 50-55 year old person who is nearing retirement – these days, we come across a number of people who wish to or have already retired in their 40’s as well!. If such a person has a net worth of say 8-10+ crores and needs about 15-20 lakhs annually for his/her household expenses and is comfortable with equities, he/she can easily continue to allocate a significantly large part of their net worth to equities.

Depending on whatever decision one arrives at, the key to building and growing wealth is saving and allocating the investments wisely and if one does decide to invest in equities, choose companies that grow their business value with time, have a competitive advantage and are run with high standards of corporate governance. One can choose to do that on their own or look at a portfolio manager who is well aligned with the investors’ objectives.

We must add that the above can serve only as a generic guide. It is ideal to spend time with a financial planner and arrive at the best solution, given personal circumstances, preferences and comfort. We spend a lot of time thinking about how to grow our business/grow salary, and optimise our expenses. If one were to just spend a couple of days to plan out the financial future, invest wisely and monitor the investments/portfolio manager regularly, the time spent would enable us to meet a lot of our needs, wants and desires; besides allowing us to spend our time where it’s best needed!