Debt instruments are quite becoming famous because of its obvious nature of providing decent returns with safety of capital. Further investors willing to add extra 1%-2% returns can look after credit risk funds which invest in debt instruments.
Still, we as an investor often want to chase high returns and don’t want to compromise for decent returns. But debt instruments are no way to ignore because of its various advantages:
- Debt provides stability to a portfolio as it reduces the volatility
- Debt helps in meeting short term goals
- Coupons on debt instruments is a regular source of income
- Indexation benefits available in debt mutual funds
And the list goes on….
Therefore it’s prudent to have a certain proportion of debt in a portfolio. But the question is how much?
Well there can be 3 broad frameworks to arrive at an ideal proportion of debt:
FRAMEWORK 1: 100 – age rule
According to this framework, debt % in a portfolio can be arrived at using the 100 minus your age rule, where the debt proportion in a portfolio will be equal to your age and remaining will be equity investments.
For eg: Akshay is 26 years old, so the ideal proportion of debt in a portfolio will be 26% and remaining 74% (100%-26%) will be invested in equities.
However this framework is very basic and sometimes lacks practicality as it ignores other factors crucial to arrive at an allocation. Therefore you can look after other 2 frameworks if this doesn’t suit you.
FRAMEWORK 2: Risk profile
Risk profiles vary from one investor to another. On the basis of risk profile, investors can be categorized into 3 categories:
2.1 Aggressive: These are the investors who are willing to take high risk just in order to stand a chance to earn higher returns. They are willing to accept high volatility in their portfolio, which is surely not everyone’s cup of tea.
2.2. Conservative: These are the investors who want peaceful sleep at night and thus are ready to compromise with returns, but are not willing to take high risk.
2.3 Balanced: Between aggressive and conservative investors, there comes an investor with a balanced risk profile. As the name suggests, these are the investors with a balanced risk profile i.e. they are willing to take calculated risk just to have that added alpha in their portfolio, but equally are conservative to safeguard their portfolio against volatility.
Thus using this framework, allocation of debt in a portfolio can be:
|Type Of Investor||Debt Allocation In Portfolio|
Thus identify in which category of investor you fit in, and allocate debt in your portfolio accordingly.
If you face any difficulty in identifying in which category of investor you fall in, then you can go ahead with approach 3 to arrive at your allocation.
FRAMEWORK 3: Time To Goal
Goals have a special place in each and everyone’s life and achievement of those goals give a tremendous amount of satisfaction. But, Investing your hard earned resources in wrong assets with adverse returns will only lead to delay in achieving your goals and trust us, the pain is real!
Goals can range from a short term goal like buying a phone, planning a vacation, etc. to a long term goal like buying a house, marriage, education etc.
Just to give you a perspective, investing 100% of your resources in equities for the goal you are willing to achieve in the next 1-2 years can be a major allocation blunder.
Thus depending on how much time is remaining to achieve your goal, allocation of debt in a portfolio can be:
|Time To Goal||Debt Allocation In Portfolio|
|Next 3 Years||90%-100% in debt|
|3 – 7 Years||40%-60% in debt|
|Beyond 7 Years||0%-10% in debt|
So these were the broad 3 frameworks that you can apply to arrive at an ideal proportion of the debt mix.
Do let us know which framework you find most suitable 🙂