- Date : 05/11/2022
- Read: 4 mins
The approach towards ideal debt-equity allocation
Your investment portfolio should be a bouquet of different investments. Asset allocation is all about earmarking your funds across these investments in a specific ratio. Equity and debt are the two major components in any portfolio. Between your grandfather’s portfolio which only had fixed deposits to your techie nephew who is excited about cryptocurrencies, you must balance the extremes and choose the ideal. You have to understand what is debt and equity and how to allocate them as per your financial goals.
Here are some of the factors that influence a person’s debt-equity allocation
- Age – Young investors can afford higher equity exposure as they have a longer duration to recover from potential downturns.
- Risk appetite – Some investors prefer a conservative approach which is reflected in their high debt-oriented investments. Investors with an aggressive approach go for bigger equity allocation in their investment portfolios.
- Circumstances – Circumstances in life like marriage, childbirth, medical problems and other family commitments can alter a person’s debt and equity proportion.
- Investment duration – How long the investor wishes to stay invested also dictates the investment choices. Someone investing for the short term will avoid high-risk equity investments and long term debt investments like PPF.
- Tax planning – Investment choices are also influenced by tax savings. If you prefer tax savings in investments, you will have more debt-oriented options.
While your ideal asset allocation may get influenced by these or other factors, you must avoid blindly following these aspects,
- Age – Just because you are young may not mean that you can invest more, in the long term and aggressive investments. If you have a young family, ageing parents, home loans etc. to take care of, your age shouldn’t be of much influence on your investment choices.
- Peer influence – Your portfolio allocation should not blindly reflect your friend or family member’s investments. Set your investment goals and holding period, and stick to them rather than joining the herd while reacting or avoiding market sentiments.
- Rules of thumb – There’s the rule of 100 (or 110) where you subtract your age from 100 to get your equity investments. The 60-40 rule recommends 60% investment in a diversified stock portfolio and 40% in bonds. Refer to the rules of thumb but improvise them to suit your financial journey and goals.
For the ideal debt-equity allocation that is unique to your requirement, following these steps will help you invest prudently
- Risk appetite – Your risk tolerance has a direct effect on your debt equity allocation. Debt investments will provide returns with steady interest rates and without the risk of underperformance, which is ideal if your risk tolerance is low. It may lose the race if the market is in a boom and fail to beat a stiff inflation rate as well. Someone with the highest risk appetite would choose equity for creating wealth over debt investments - the higher the tolerance higher the equity investment.
- Investment Goals – Buying a car in two years, a house in five, and planning to retire after 30 years? What are your investment goals and how far they stand from now will decide your asset allocation decision? Short-term goals should be met through low-risk investments while long term goals can be planned with high-risk equity allocations held for a long duration.
- Keeping it dynamic – Depending on changes in your financial position, risk tolerance and life events, you must monitor and regulate your investments regularly. You may have to rebalance your investment from time to time, which will alter your debt-equity proportion.
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While there is no one-size-fits-all in debt-equity allocation, there can be one right approach towards designing one. The trick is to identify the factors that will influence your investment decision, the ones that may influence but shouldn’t, and the ones that definitely should.