Selection of Asset Mix

Based on your objectives and constraints, you have to specify your Asset allocation, that is, you decide how much of your portfolio has to be invested in each of the following asset categories:

1. Cash
2. Bonds
3. Stocks
4. Real estate
5. Precious metals
6. Other

The thrust of this article will be on determining the appropriate mix of ‘bonds’ and ‘stocks’ in the portfolio. Before we examine this issue, note the following:

The first important investment decision for most individuals is concerned with their education meant to build their human capital.

The most significant asset that people generally have during their early working years is their earning power that stems from their human capital. Purchase of life and disability insurance becomes a pressing need to hedge against loss of income on account of death or disability.

The first major economic asset that individuals plan to invest in is their own house. Before they are ready to buy the house, their savings are likely to be in the form of bank deposits and money market mutual fund schemes. Referred to broadly as ‘cash’ these instruments have appeal because they are safe and liquid.

Once the investment in house is made and reasonable liquidity in the form of ‘cash’ is maintained to meet expected and unexpected expenses in the short run, the focus shifts to planning for the education of children, providing financial security to the family, saving for retirement, bequeathing, wealth to Heirs, and contributing to charitable activities. In this context ‘stocks’ and ‘bonds’ become important. Very broadly, we define them as follows:

‘Stocks’ include equity shares (which in turn may be classified in to income shares, growth shares, blue chip shares, cyclical shares, speculative shares, and so on) and units / shares of equity schemes of mutual funds (like Master shares, Birla Advantage, and so on).

‘Bonds’ defined very broadly, consist of non-convertible debentures of private sector companies, public sector bonds, gilt edged securities, RBI Savings Bonds, units/shares of debt oriented schemes of mutual funds, National Savings Certificates, Kisan Vikas Patras, bank deposits, post office savings deposits fixed deposits with companies, deposits in provident fund and public provident fund schemes, deposits in the Senior Citizen’s Savings Scheme, and so on. The basic feature of these investments is that they earn a fixed or near fixed return.

Should the long term stock bond mix be 50:50 or 75:75 or 25:75 or any other?

Referred to as the strategic asset mix decision (or policy asset mix decision), this is by far the most important decision made by the investor. Empirical studies have shown that nearly 90 percent of the variance of the portfolio return is explained by its asset mix. Put differently, only about 10 percent of the variance of the portfolio return is explained by other elements like ‘sector rotation’ and ‘security selection’. Given the significance of the asset mix decision, you should hammer it out carefully.

Conventional Wisdom on Asset Mix:

The conventional wisdom on the asset mix is embodied in two propositions:

Other things being equal, an investor with greater tolerance for risk should tilt the portfolio in favor of stocks, whereas an investor with lesser tolerance for risk should tilt the portfolio in favor of bonds. This is because in general stocks are riskier than bonds and hence earn higher returns than bonds. Exhibit portrays the risk return relationship for various types of stock and bond investments. James H Lorie summed up the long view well when he stated: The most enduring relations in all finance perhaps is the relationship between returns on equities (or stocks) and returns on bonds. In all periods of American history, British history, French history, and German history, equities (stocks) have provided higher returns than bonds. A similar observation can be made when we look at the returns on stocks and bonds in India for the last few decades.