Credit card issuers use a decision model to decide whether or not to issue a credit card to an applicant, and the credit limit to offer in case they decide to issue one. It is the same with loan companies. In all such cases, the decision model analyses the information provided by the applicant and to arrive at a decision. The yardsticks of such decision models are based on statistics of past experiences.

Similarly, it is possible to have a model that would suggest the mix of asset categories for an investor though judgement too plays a key role in addition to the standard tools.

The optimum investment allocation for an investor would depend on his or her wealth cycle and life cycle.

The Wealth Cycle

People typically go through three wealth cycle phases:

• Accumulation/Sowing: Where the investor's income is much more than current needs. You are then in a position to set apart something for the future.
• Distribution/Reaping/Harvesting: Where the person's needs cannot be fully met by current income. The gap would need to be met out of savings or loans.
• Transition: This is a phase between the accumulation and distribution phases, when the distribution needs are very clearly in the person's radar, although the harvesting may not yet have commenced.
• Windfall: This is a phase that touches people's lives only occasionally. Windfall could be winning from a lottery, super-normal profits booked on investments, inheritance, etc.

The risk-based asset allocation would be different for each phase. The Association of Mutual Funds of India proposes the following mix:

Accumulation Phase

Distribution Phase

(Note - Tables reproduced with permission of the Association of Mutual Funds of India)

There is a widely-cited and used thumb rule to determine size of debt portfolio based on age which holds that the percentage of your debt portfolio should be about equal to your age. This rule should not, however, be stretched too much -- else a person who lives beyond 100 would end up short-selling equity -- hardly an age for such portfolio management style!

During the transition stage, an investor would be well advised to park increasing proportions of money in liquid assets. Once the expected goals have been achieved, the investor can go back to the distribution suggested by strategic asset allocation.

The windfall situation is interesting. When an investor wins a lottery, he or she realises how many so-called friends or relatives there are! -- including many who have not bothered to maintain contact for several years. Money in the bank is always a temptation for a splurge (a person happily accustomed to train travel, overnight deciding to buy a Mercedes Benz!) or altruism.

It would be prudent not to blow up the money, nor invest all of it at the same time. The money could first be invested in a safe and liquid avenue -- liquid schemes, for instance. Progressively, the money can be invested in equity or other investments, as per the preferred asset allocation. Through progressive investments, the investor can avail of the benefits of systematic investment planning.

Thus, during the transition and windfall stages, the investor's asset allocation would be temporarily at variance from that suggested by the strategic asset allocation approach.

The Life Cycle

Birth, childhood, graduation, early employment, marriage, children, education / marriage of children and retirement -- these are the life phases that people normally go through. The asset allocation and investment choices that are made would need to keep the life cycle in mind.

Thus, in the early stages of one's professional career, the investment mix would be more like that set out above for the "Accumulation" phase in the wealth cycle. Towards retirement, it would be more like the "Distribution" phase in the wealth cycle. The investment mix would need to specifically provide for expected spikes in expenses in between ("Transition" phase), such as for buying house, marriage of children, etc.

An aggressive growth fund would find a place in the portfolio of younger investors with a propensity to take risk. Older investors would find the equity portion of their portfolio dominated by equity income funds. As seen earlier, closer to a large and sure fund outflow for people who are in the transition phase (some requirement of funds in the radar), moneys would be transferred to money market or other debt funds. Thus, scheme selection becomes a function of both risk profile and cash flow needs of an investor.

The choice of funds for an investor would depend on her investment philosophy and portfolio. The kind of investment portfolio that is appropriate for different types of investors is as follows�and you can choose appropriate funds that match these various styles:

Defensive investor:

• There should be adequate, though not excessive, diversification (10 -- 30 stocks);
• Each company should be large, prominent, and conservatively financed;
• Each company should have a long record of dividend payments;

The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years. (25 times average; 20 times last 12 month period).

Enterprising investor:

• Buying in low markets and selling in high markets;
• Buying carefully chosen "growth stocks";
• Buying bargain issues of various types;
• Buying into "special situations";

Some experts believe that there is no such thing as a moderately aggressive investor, mildly conservative investor, and such other shades of differences. Investors are either aggressive or conservative. "The aggressive (enterprising) investor must have a considerable knowledge of security values -- enough, in fact, to warrant viewing his security operations as equivalent to a business enterprise.

There is no room in this philosophy for a middle ground, or a series of gradations, between the passive and aggressive status. Many, perhaps most, investors seek to place themselves in such an intermediate category; in our opinion that is a compromise that is more likely to produce disappointment than achievement. As an investor you cannot become 'half a business-man', expecting thereby to achieve half the normal rate of business profits on your funds".

Excerpted from: Indian Mutual Funds Handbook by Sundar Sankaran. Price: Rs 395.

Sankaran is an authority on the subject of mutual funds, has conducted more than 200 seminars on the subject all over India.

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