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What is ideal asset allocation for buy and hold?

Asset allocation is an oft-misunderstood term. It is at times mistaken for stock selection. In fact, asset allocation is a much broader term. There are two levels of asset allocation that we need to be aware of. The first is the financial plan level asset allocation that encompasses asset classes such as equity, debt, liquid assets, gold etc. This is normally called the first level of asset allocation. Our focus here is on the second level of asset allocation, which is the allocation within an asset class. For example, within debt how much should you allocate to long term debt and short term debt? Similarly, how much should you allocate in government debt and how much in corporate debt? How much should you allocate to “AAA” rated debt and how much to “AA” rated debt?
Asset allocation with respect to equities
Equity asset allocation is normally a subjective exercise and it depends on the market realities and on your risk appetite. Here again, the issue can be approached in different ways. How much should you allocate to index stocks and how much to non-index stocks? How much should you allocate to growth stocks and how much to value stocks? Lastly, how much in large cap stocks and how much in mid and small cap stocks? Let us look at the market cap based allocation of your money in greater detail.
SEBI has defined the top-100 stocks based on market cap as large stocks, while the ones after these are mid and small cap stocks. This classification is meant for mutual funds and the definition can be quite fluid. According to popular measure, companies with a market cap above $10 billion (Rs7,000cr) are large caps, while stocks having market cap between $2 billion and $10 billion are midcaps. Normally, stocks with a market cap of less than $2 billion are classified as small caps in the Indian context. Here are 3 factors that will determine your asset allocation across capitalizations.

1. Your risk capacity and appetite for risk
Remember, risk capacity and risk appetite are two different things altogether. A trader with a gambler’s instinct may have a huge risk appetite but he may not have substantial risk taking capacity. Similarly, a high net worth investor who is above the age of 60 may have substantial risk taking capacity but may not have the risk appetite. Your asset allocation is normally a trade-off between your risk capacity and risk appetite. You must stretch yourself to bring these two factors as close as possible and that is where your ideal asset allocation will exist. For those with a higher risk appetite and relatively higher risk taking capacity, a greater exposure to mid caps and small caps may be advisable. But for someone with lower risk appetite and risk capacity, a greater exposure to large caps may be still better.

2.Valuations of mid caps versus large caps

What are the valuations that mid caps and small caps are quoting at? Just 6-7 months back, mid caps and small caps were quoting at a smart premium over large caps, which was at a historic high. You normally decide your allocation in terms of a range and when mid cap valuations are stretched, it is advisable to shift your mid caps to the lower end of the range and your large caps to the upper end of the range. In the last 7 months, the mid cap index has corrected over 16% and individual mid caps have corrected 40-70%. This calls for raising your mid cap allocation higher from the lower end of the allocation range. You will have to consider relative P/E ratios, historical P/E Ratios and the P/E ratios of each of these classes vis-à-vis the index.

3. Whether our focus is on Alpha or Beta
What is the difference between Alpha and Beta in stock markets? Beta represents the market risk and is represented by the risk of the index like Nifty and Sensex. So the index will have a Beta of 1. Stocks with a Beta of more than 1 will be aggressive stocks and stocks with a Beta of less than 1 are defensive stocks. When you buy large cap stocks, you will get returns that are slightly above the index returns, assuming that you create a well diversified portfolio. In case of mid caps and small caps, the returns can be substantially higher than the index, but the risk is also commensurately higher.
Generalized asset allocation in terms of market cap
Asset allocation is normally quite subjective. But if you were to assume the case of an individual investor looking to create wealth through equities, the ideal asset mix can be:

Asset Class Allocation

Percentage Allocation


Very Large Caps (above $50 bn)


Matured stocks tracked very extensively by analysts.

Large Caps ($10 bn to $50 bn)


Large caps with still room to grow and create wealth.

Mid Caps ($2 bn to $10 bn)


The next set of large caps with robust business models and delivering growth and margins.

Small Caps (Less than $2 bn)


Real high risk stocks with potential for super normal returns. They are like well researched call options.

The above market cap allocations are purely indicative and it is best to consult a financial advisor before adopting any asset allocation model.


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