How you allocate your assets between equity and debt is one of the most important decisions you’ll make when investing. In addition to being riskier, equity investments, such as stocks, also offer higher returns. Compared to equity investments, bonds offer a lower return, but they offer a lower level of risk.
What’s the ideal equity-to-debt allocation for you? Depending on your personal circumstances and risk tolerance, that will differ. However, you can make an informed decision if you follow some general guidelines.
Equity 101
An equity investment is a form of ownership in a specific company. In essence, you are buying a small piece of the company when you purchase a stock.
If the company does well, your stock value will rise. As such, you can sell it at a profit. In the event that the company performs poorly, though, the value of your stock might decline. Consequently, you might lose money.
Over the long term, equity investments can provide higher returns than debt investments. However, they are also more risky. It is always possible to lose money when you invest in stocks due to their short-term volatility.
Pros:
- Over time, higher returns are possible.
- Potential for long-term growth.
- Capital appreciation potential.
- Dividends and interest income are potential sources of income.
Cons:
- Investing in equity is more risky than investing in debt.
- It is possible for prices to fluctuate more volatilely.
- Illiquidity.
- It is possible to lose money.
Debt 101
A debt investment is a loan you give to a company or government. Bonds, for instance, are essentially loans between buyers and sellers. Over a set period of time, the issuer will repay the principal and interest on the bond.
The most common examples of these fixed-income investments are treasury bills, commercial papers, certificates of deposit, corporate bonds, and government bonds.
While debt investments are less risky than equity investments, they offer lower returns. Stocks are more volatile than bonds, so you have a lower risk of losing money if you invest in them.
Pros:
- Investing in bonds is less risky than investing in equity.
- There is less volatility in prices.
- In most cases, the principal is repaid.
- Income stability.
- Liquidity.
Cons:
- A lower potential return.
- There is less potential for growth.
- Capital appreciation is less likely.
- Dividends and interest are not possible.
- There is an interest rate risk.
How to Choose the Right Allocation
When it comes to allocating your assets between equity and debt, there is no one-size-fits-all solution. Generally, your risk tolerance and individual circumstances will determine the ideal allocation for you.
In making your decision, you should consider the following factors:
- Age. Younger investors can afford to take on more risk because they have more time to ride out market volatility. Due to less recovery time from losses, older investors may choose less risky assets.
- Income. Taking on more risk may be easier if you earn a high income. On the other hand, low-income investors may want to invest in assets with less risk.
- Risk tolerance. What is your comfort level with risk? In the case of risk-averse investors, conservative assets might be a better choice. Investing in more aggressive assets, however, may be a good idea if you are more comfortable with risk.
Equity-Debt-Allocation Based on the “100 Minus Age” Rule
In asset allocation, your investments are divided among different asset classes, such as stocks, bonds, and cash. To determine the percentage of your portfolio that should be allocated to stocks, subtract your age from 100. For example, a 30-year-old should allocate 70% to stocks and 30% to bonds.
What is the rationale behind 100 minus age? The younger the investor, the more time they have to recover from losses. Therefore, the younger investor can afford a bigger risk. By allocating more of their portfolio to bonds as they age, investors can reduce their risk exposure and recover from losses faster.
You could follow these general guidelines:
- Young investors. 70% equity, 30% debt
- Middle-aged investors. 60% equity, 40% debt
- Older investors. 50% equity, 50% debt
It is important to keep in mind that the 100 minus age rule is only a guideline. You may need to adjust your asset allocation based on your individual circumstances.
For instance, if you have a high-paying job and won’t retire for many years, you may feel comfortable with a higher stock allocation. On the flip side, if you are planning to retire early from a low-paying job, you may want to increase your bond allocation.
As part of an investment strategy, asset allocation is just one component. Investing decisions should also take into account your risk tolerance, time horizon, and financial goals.
Among the pros and cons of the 100-minus-age rule are:
Pros:
- It is simple and easy to remember.
- Assists in determining asset allocation.
- Adaptable to individual needs.
Cons:
- Investors’ risk tolerance and financial goals are not taken into account.
- Not suitable for all investors.
- Some investors may find it too simplistic.
In addition to these asset allocation guidelines, you may wish to consider the following:
- The rule of 110. According to this rule, you should allocate stocks a percentage of your portfolio based on your age subtracted from 110.
- Asset allocation is based on age. Using this approach, your portfolio is allocated according to your age and risk tolerance. The portfolio of a 30-year-old investor with a high-risk tolerance might contain 80% stocks and 20% bonds.
- The target-date fund. In this type of mutual fund, assets are automatically allocated as you get closer to retirement.
It is important to note that these are just general guidelines. Financial advisors can assist you in determining your right allocation.
How to Rebalance Your Portfolio
You may drift away from your target asset allocation over time. You may experience this due to market fluctuations or a change in your circumstances. To ensure that your portfolio remains aligned with your goals, you should rebalance it periodically.
Investing in assets that underperformed can be rebalanced by selling those that outperformed. By doing so, you will be able to keep your portfolio balanced and reduce your risk.
To rebalance your portfolio, follow these steps:
- Determine your asset allocation. Ideally, your portfolio should include a mix of stocks, bonds, and cash. Investing goals and risk tolerance will determine your asset allocation.
- Track your portfolio’s asset allocation. You may find that the asset allocation of your portfolio drifts away from your target asset allocation over time. The reason for this is that individual investment prices fluctuate.
- Rebalance your portfolio when it gets out of balance. Rebalancing your portfolio can be done in two ways:
- Sell high-performing investments and buy low-performing investments. As a result, you will achieve your target asset allocation for your portfolio.
- Contribute new money to your portfolio in a strategic way. It may be a good idea to devote all your new money to your underweighted asset classes until you have a more balanced portfolio.
- Regularly rebalance your portfolio. Keeping track of your risk tolerance and asset allocation will help you remain on track.
The following tips will help you rebalance your portfolio:
- Set a rebalancing schedule and stick to it. Maintaining discipline and avoiding emotional investment decisions will help you avoid making poor investments.
- Use a target-date fund or other automated rebalancing service. You can easily and conveniently rebalance your portfolio this way.
- Don’t be afraid to sell winners. When investments are performing well, it can be tempting to hold onto them. But, it may be time to rebalance your portfolio if these investments have taken up too much of your portfolio.
- Consider using tax-advantaged accounts for rebalancing. You may have to pay capital gains taxes if you sell investments in a taxable account. A tax-advantaged account, such as an IRA or 401(k), can help you avoid this problem.
- Rebalance your portfolio after large investments or withdrawals. You will be able to maintain an asset allocation that is aligned with your investment goals and risk tolerance.
- Rebalance gradually. Your portfolio doesn’t need to be rebalanced all at once. It is possible to gradually rebalance your portfolio by selling some overweight assets and buying some underweight assets.
To achieve long-term success, it is important to rebalance your portfolio periodically. This helps you stay on track with your investment goals and risk tolerance.
Conclusion
A well-diversified portfolio should include both equity and debt. Based on your personal circumstances and risk tolerance, you will need to determine the ideal equity-to-debt allocation for you. When allocating your assets, you should carefully consider these factors.
Additionally, asset allocation is not a static strategy. Your asset allocation may need to be adjusted as your financial goals and risk tolerance change.
Finally, you can develop an asset allocation strategy that’s right for you by working with a financial advisor. You can work with an advisor to determine your investment time horizon, risk tolerance, and financial goals. In addition, they can guide you in choosing the right mix of equity and debt investments.
FAQs
What is equity?
Investing in equity means owning a part of the company. In other words, the stock you buy represents a portion of the company. An equity investment can yield higher returns than a debt investment, but it is also more risky.
What is debt?
A loan that must be repaid with interest is called a debt. By investing in debt, you are lending money to companies or governments. Debt investments tend to be less risky than equity investments, but their returns tend to be lower.
How do equity and debt allocations differ?
Investing in equity securities, such as stocks, is a percentage of your overall portfolio. An investment portfolio‘s debt allocation refers to its percentage allocated to debt securities, such as bonds.
How do you decide how much to allocate to equity and debt?
In response to this question, there is no one-size-fits-all solution. Your investment goals, risk tolerance, and age will determine the best equity and debt allocation for you.
What are some factors to consider when making an equity vs. debt allocation decision?
An equity vs. debt allocation decision needs to take into account the following factors:
- Age. To reduce your risk, you may want to allocate more of your portfolio to debt than equity as you age.
- Risk tolerance. For risk-averse investors, debt may be a better choice than equity in their portfolio.
- Investment goals. To achieve higher long-term returns, you may want to allocate more of your portfolio to equity.
- Current economic climate. Equity vs. debt allocation decisions are also influenced by the current economic climate. For instance, it may be a good idea to allocate more of your investment portfolio to equity if the economy is doing well.
How often should you rebalance your equity vs. debt allocation?
Investing in equity and debt should be rebalanced regularly, once or twice a year. By doing so, your portfolio will remain aligned with your risk tolerance and investment objectives.
Featured Image Credit: Photo by Mikhail Nilov; Pexels; Thank you!
