Mutual Funds are an ocean of investment opportunities for every class of investors whether they belong to aggressive, moderately aggressive, or risk-averse. The percentage of the assets in the portfolio based on the investment goals is generally referred to the asset allocation. An ideal asset allocation is based on the age or investment goals and other factors like the investment horizon of the investor.
Given below are a few rules that help in building a healthy and profitable investment portfolio.
What is asset allocation?
Investors can invest in equity or debt or hybrid funds that have a healthy mix of equity or debt. Every investor will have a preferred category of investment based on their risk-return perception and investment goals. But a sound portfolio needs to have a healthy mix of both equity and debt to mitigate the risks as well as get good returns that are able to beat inflation and maximize investor’s wealth.
Most investors even today rely on the experience or the portfolio of a fellow investor to build their portfolio. However, this is not a good way to build your assets. What may work for a person may not be suitable for another. Hence it is advisable to first understand and evaluate the basic parameters of investment like the cost of investment, risk assessment, investment horizon, investment goals, and most importantly returns expectations.
For example, a person nearing retirement will not look out for aggressive investment rather will prefer an investment that can be an alternate source of steady income. On the other hand, a person in their 20s or 30s will aim at wealth maximization and prefer more equity and equity-related investments.
What is the general rule regarding investment based on age?
There are various basic rules and guidelines that seasoned investors agree to be tried and tested formulas. The first and foremost rule while investing is considering the age of the investor. This general rule of asset allocation is also known as the ‘rule of 100’ or the ‘100 age rule’
Rule of 100 minus Age
It merely states that the age of the investor should be subtracted from 100 and the resultant number should be the proportion of equity in one’s investment portfolio.
For example, if the age of a person is 35, then the equity allocation in their portfolio should be at least 65% (100-35). The balance of the portfolio can be allocated to debt, real estate, cash, and other investments.
Furthermore, investors can be aggressive or conservative with the balance asset allocation based on their risk appetite. A conservative inverter will prefer more debt as compared to an aggressive inverter who may prefer to invest in real estate at an early age. Some investors may prefer to have liquid cash or may prefer to invest more in gold to ensure they have enough liquidity in case of emergencies.
Watch this video to learn more about equity rule:
What are the limitations of this assumption?
The basic limitation of this rule is its generalization. As mentioned above, what may work for one person may not be true for another. The rule does not factor in other considerations like risk perception, other obligations, investment goals, etc.
For example, the rule says that a person in their 30s should have more equity than debt as their assets in the portfolio. However, it does not consider their risk profile but simply assumes them to be aggressive investors. In this case, if the investor has a lower risk appetite or is aiming at a regular and steady alternate source of income, they may prefer more debt in their portfolio.
While this rule helps the new investors navigate their way in the stock market or mutual funds market, it is prudent to consider other relevant factors too so the investment goals are met efficiently.
What are a few other rules of investing that can help investors create a profitable portfolio?
Apart from the basic rule mentioned above, there are a few more rules that are usually adopted by investors to maximize their wealth. These general rules are mentioned below.
1.Rule of 72
This is the basic rule that is widely applied by investors to know the time frame required to double the investment. Under this rule, investors have to divide 72 by their average rate of return to get the number of years it will take to double their investment.
For example, if the average rate of return of the portfolio is 10% then after dividing 72 by 10, it will take approximately 7.2 years for the portfolio to double.
2.Rule of 114
Similar to the above rule, this rule allows the investor to know the number of years it will take the investor to triple their investment. Under this rule, investors will have to divide 114 by the average rate of return of the portfolio.
Considering the above example, the investment will triple in approximately 11.4 years (114/10)
3.Rule of 144
This rule lets the investor know how many years it will take for their investment to become 4 times. Under this rule, investors can divide 144 by the rate of return to get the required number of years.
Considering the above example, it will take 14.4 years (144/10) for the investment to be 4 times.
4.Rule of the emergency fund
This rule says that a person needs to allocate a minimum of 6-12 months as emergency funds so they can have a sufficient safety net in time of crisis.
5.Rule of 10,5, 3
This rule mentions the average returns that should be expected from the various assets in their portfolio. According to this rule, the average returns from equity have to be approximately 10%, returns from debt have to be approximately 5% while returns from savings accounts have to be approximately 3%.
The rules mentioned above have traditionally been adopted by the investors to have a successful investment portfolio. However, it is essential to understand that one cannot always follow these rules blindly without giving any weightage to factors like risk perception, other financial obligations, investment goals, returns expectations, etc.
1. What is the rule of 10% while investing?
A. This rule states that investors have to save and invest a minimum of 10% of their monthly or annual income to have a considerable or sufficient retirement fund.
2. What is the rule of withdrawal?
A. The rule of withdrawal states that if an investor wishes for the retirement fund to last for their retirement completely then the maximum they can withdraw from the fund is 4%. This percentage is further adjusted to the current inflation rate so the withdrawal per annum is sufficient to meet their expenses as well as enough to last their full retirement.
3. Is the asset allocation rule applicable for every investor?
A. Asset allocation rule is the general rule based on specific risk perception of the investors. It does not account for other factors like investment goals, returns expectations, investment horizon, etc. Hence, although it is quite favorable to new and aggressive investors, it should be followed with caution.
4. What is the net worth rule?
A. The net worth rule refers to the average net worth a person should have based on their age and income to be considered wealthy. According to this rule, the investor has to multiply their age and the gross total income and divide the product by 10 (20 in the case of Indians)