Personal Finance

Choose assets based on income volatility

B Venkatesh | Updated on October 28, 2018 Published on October 28, 2018

The 100-minus-age asset-allocation rule won’t fit all types of salaried people

Asset allocation plays an important role in your wealth creation process. One of the factors that determine your asset allocation is the volatility of your income. In this article, we discuss why you have to adjust your asset allocation based on the volatility of your income. We then offer asset-allocation strategies that you can adopt to create goal-based portfolios.

Active-income asset

You own two assets during your working life: active-income asset — which is the present value of your future active income — and your investment capital. Active income refers to the income you earn by working. When you start working, your active-income asset is large because you have a long career ahead. Your investment capital is near zero. As you progress in your career, your active-income asset reduces as you get closer to retirement. But your investment capital grows as you save every month and invest.

Let’s take the example of two individuals aged 30. The ‘100-minus-age’ asset-allocation rule suggests that both should have 70 per cent in equity and 30 per cent in bonds. But this rule fails to consider the volatility of the active-income asset. Suppose, one works for a State government and the other in the private sector.

The government employee has a stable income adjusted for inflation. The increase or upside in salary is limited, but so is the risk of losing the job or suffering a pay cut. In contrast, the private-sector worker has the potential to exponentially increase her salary. But she also has a high risk of losing her job or suffering a pay cut.

Therefore, the active-income asset is bond-like for the public-sector employee and equity-like for the individual working in the private sector. Given that all working individuals have only two assets, we should adjust the risk of our investment capital based on the volatility of our active-income asset.

And that means calibrating our asset allocation to the volatility of our active-income asset. How should you decide your asset allocation?

If you want to apply the ‘100-minus-age’ rule, consider marking down your equity allocation by 15-20 percentage points if your active-income asset is volatile. For instance, if you are 30 and work in a cyclical industry, or if a significant part of your income is variable-pay, your equity allocation should be 50-55 per cent. And if your active-income asset is stable, increase your equity allocation by 5-10 percentage points over the ‘100-minus-age’ rule. This approach applies only to portfolios created for non-high-priority goals.

Floor-upside rule

What about high-priority goals? These are goals that you cannot postpone. Suppose, you want to accumulate wealth to fund your child’s college education.

Even though this portfolio has a longer time horizon, it should carry lower equity allocation to reduce the risk of goal failure.

Your asset allocation should then be based on the floor-upside rule. Suppose you want to send your child to a college in the US 10 years hence. Calculate the approximate cost of the programme 10 years from now, applying a suitable inflation rate on the current cost. Now, consider the second-best education option and measure its costs, too. Suppose the difference between the two choices is ₹50 lakh.

You should invest in a bank recurring deposit every month over the next 10 years so that you have enough money to fund the second-best option.

This cash flow provides certainty to the second choice, creates the floor for the portfolio and accounts for your bond allocation.

Your monthly investment in equity funds should be such that the amount accumulates to ₹50 lakh in 10 years based on 10.8 per cent post-tax expected return.

This cash flow provides for the upside in the portfolio, aiming to fulfil your first choice, and accounts for your equity allocation.

The writer is founder of Navera Consulting. Send your feedback to [email protected]

Published on October 28, 2018
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