How much should you invest in debt and debt funds?

It was Nisha’s first time living alone. She had just moved to a new city. She had a new job. And she was very excited about taking care of herself all on her own. Things were going great until she went shopping in the city’s local market later that week. Since her paycheck was due one week later, Nisha only had the little money she had brought along with her.

She went to the market with Rs. 2,000, hoping to get some utilities and groceries for the week. Later, once her salary was paid, she could return to the market and splurge on things she wanted, or so she thought. Looking around the many colorful stalls, Nisha soon lost herself in the potpourri of things available to buy. And before she knew it, she’d spent about Rs. 1,500 on a ton of sweets, fast food and chocolates. Left with just Rs. 500 to get her essentials, Nisha could only just scram in about a few of the things she really needed before her money ran out.

For the rest of the week, she had no real food to survive on. Just the sweets and processed foods she’s bought. And they ran out quickly. 

What did Nisha learn from this, though? 

Well, she learned that asset allocation is important. Knowing how to distribute money across the available needs is an art, and quickly, Nisha learned to get better at it.

Asset allocation is a part of everyday life. And just like it plays a key role in how you spend money at the market, it also proves to be very important when you are making your investments.

Throughout this module, we saw how the debt market is made up. But the question remains - how much to invest in debt funds and debt? Is there a magic number? Is there a one-size-fits-all approach?

The answer to these questions lies in one place - asset allocation.

What is asset allocation, then?

You know by now that there are different asset classes, isn’t it? There’s debt, there’s equity, there are cash and cash equivalents, there are commodities, there are derivatives, and there’s real estate, among others. Asset allocation holds the answer to how much you should invest in these different asset classes, if at all? 

So, take a look at the question we’ve asked in the title of this chapter -  How much should you invest in debt and debt funds? The answer to this lies in asset allocation. 

Asset allocation is the strategy that helps you determine which asset categories to include in your investment portfolio. It enables you to figure out how much of your investment corpus to allocate to different asset classes - as well as to different assets within the same asset class. 

Asset allocation helps you answer these questions:

• Which asset class to invest in?
• How much to invest in those asset classes.

So, breaking it down, here’s what asset allocation looks like.

• First, you figure out which assets you wish to include in your portfolio. Most commonly, investors start off by considering equity, debt and cash.
• Then, you decide how much money to park in each asset class.

Simple, isn’t it? But how do you actually make that decision? 

How do you figure out how much to invest in equity, if at all?

And how much to invest in debt funds and debt, as this chapter asks right at the beginning?

Do you just go about it based on your preferences? Well, not really. Because then, you would be doing just what Nisha, in the example we saw earlier, did with her money. She impulsively spent it on her wants rather than her needs. 

So, one thing is clear. Your asset allocation depends on your requirements. More specifically, the question of how much to invest in different asset classes depends on the following factors:

• Your investment horizon
• Your risk tolerance level

Let’s break these down and see how they impact how much you should invest in debt and debt funds.

• Your investment horizon

Over the course of your life, you’ll have many goals, right? More often than not, they’ll come with a deadline attached. Here’s a list of some such possible goals.

Goal	To be achieved within
Refurbishing your house and redoing your interiors	1 year
Taking an international vacation with your friends	1 year
Buying your dream house	5 years
Saving up to pay for your child’s college education	8 years
Buying your second home	12 years
Creating a retirement corpus	20 years

Since each goal has a due date - a deadline - you can easily choose investment options that will likely give you the returns you’ll need to fund these goals around the time you’ll need them. For instance, given that you want to take an international vacation within the year, you’ll look for short-term investment options that will help you generate the amount needed for the trip within 1 year’s time. And since you want to save up for your child’s education within 8 years from now, you can look at medium-term investment options.

This is what the investment horizon is all about. It tells you how long you need to hold an asset. Typically, investment horizons can be one of three types:

• Short-term
• Medium-term
• Long-term

Equity investments tend to be much more volatile than debt in the short run. On the other hand, they also have the potential to generate higher returns over the long run. So, typically, based on your investment horizon, here’s what may be a good strategy.

• If you are looking to invest with a medium-term or a long-term horizon, equity investments may be a good choice.
• If you have a short-term horizon in mind, debt and debt funds may be more ideal.

So, how much should you invest in debt and debt funds?

Well, there’s no one-size-fits-all approach. The answer to ‘how much’ depends entirely on your goals and the amount you need for them. But depending on your investment horizon, you can get a better idea of how to allocate your funds between equity, debt and other asset classes. 

• Your risk profile

No two persons have the same risk tolerance levels. Think of your group of friends, for instance. The more adventurous one may be willing to take the plunge and scuba dive, while the less risk-friendly one may be content doing other things, like museum hopping or driving around a city. Just like this, there are different categories of investors too, when it comes to risk capacity.

Generally, we have three broad categories of investors:

• The aggressive investor
• The moderate investor
• The conservative investor

The aggressive investor doesn't mind taking investment risks if it means there’s an increased possibility of earning returns that are inflation-beating and higher-than-average.

The conservative investor, on the other hand, would prefer to earn steady returns even if they were not well above average, as long as it meant that there was very low risk of losing the corpus.

The moderate investor is somewhere in-between, willing to take some risks, but also keen on capital preservation.

Now, based on your risk profile, you can choose to invest in the asset classes that correspond to how much risk you can tolerate. Equity, as you’re well aware, comes with higher risk than debt instruments. So, if you are a more aggressive investor who can afford to take some investment risks, equity may be a good asset to include in your portfolio. On the other hand, if you are highly conservative and would like to keep your capital intact, you could choose debt investments, since they can offer you stable returns.

So, how much should you invest in debt and debt funds?

The answer to ‘how much’ also depends on your goals and your risk profile. As your risk tolerance goes down, the amount you allocate to debt and debt funds also correspondingly increases. 

Asset rebalancing: Using debt funds to stabilize your portfolio

Your investment horizon, your risk profile and your investment goals help you figure out how to go about asset allocation when you are first constituting your portfolio. But, year after year, the rates of return on various asset classes constantly change, depending on various microeconomic and macroeconomic factors. 

So, at some points, equity may outperform debt, while at others, equity may deliver low or even negative returns. This is where debt funds can help stabilize your portfolio. They act as a cushion against potential capital erosion from your equity side. Nevertheless, as market movements change the constitution of your portfolio, you will need to constantly rebalance your portfolio to ensure that your original asset allocation.

For example, say you start off your portfolio with a 50% allotment to equity and a 50% allotment to debt. One year later, market movements change the amount of equity and debt in your portfolio, such that equity is 57% and debt, 43%. So, you need to sell off some equity investments and reinvest it in debt, till they’re both 50-50 again. 

This is what asset rebalancing is. It is the process by which you can restore your portfolio to its original target allocation. Rebalancing brings your portfolio back to the desired asset ratio. You can do this by booking profits in outperforming assets and reinvesting those funds in the underperforming assets. 

This strategy will also help you constantly revisit the answer to how much you should invest in debt and debt funds. 

Let’s look at an example to understand rebalancing better.

Scenario 1: Equity delivers positive returns

	Equity	Debt	Equity %	Debt %	Comments
Initial investment	Rs.1,00,000	Rs. 1,00,000	50%	50%
Annual returns	12%	8%
Amount after year 1	Rs. 1,12,000	Rs. 1,08,000	≈ 51%	≈ 49%
Amount after rebalancing	Rs. 1,10,000	Rs. 1,10,000	50%	50%	Rs. 2,000 moved from equity to debt

Scenario 2: Equity delivers positive returns

	Equity	Debt	Equity %	Debt %	Comments
Initial investment	Rs.1,00,000	Rs. 1,00,000	50%	50%
Annual returns	-6%	8%
Amount after year 1	Rs. 94,000	Rs. 1,08,000	≈ 46%	≈ 54%
Amount after rebalancing	Rs. 1,01,000	Rs. 1,01,000	50%	50%	Rs. 7,000 moved from debt to equity

In scenario 1, equity outperformed debt, so you can rebalance your assets at the end of year 1 and transfer the profits from the outperforming asset (in this case equity) to the underperforming asset (in this case debt). 

In scenario 2, equity underperformed, bur debt provided a good cushion. So, to rebalance your assets at the end of year 1, you can transfer the profits from the outperforming asset (in this case debt) to the underperforming asset (in this case equity).

So, what’s the bottom line? 

You will need to rebalance your portfolio periodically, so your asset allocation remains ideal. This is also an important part of the answer to how much you should invest in debt and debt funds. It is not an exact amount, per se. But it is more of a percentage. Based on your risk profile and your investment horizon, you decide on the ideal asset allocation percentages. 

Then, as the asset allocation keeps fluctuating year on year, you rebalance your investments till the original asset allocation is restored. The bottom line, then, is that there is no ideal amount that you should invest in debt and debt funds. It varies from one investor to another. And even in the case of the same investor, it varies depending on the age and the life goals they have. 

Wrapping up

That sums up how you can decide on your asset allocation and decide on how much to invest in debt and debt funds. When done right, investments in the market can stabilize your portfolio and ensure that you have some stable returns to rely on. 

A quick recap

• Asset allocation is the strategy that helps you determine which asset categories to include in your investment portfolio. 
• It enables you to figure out how much of your investment corpus to allocate to different asset classes - as well as to different assets within the same asset class. 
• The question of how much to invest in different asset classes depends on your investment horizon and your risk tolerance levels.
• The investment horizon tells you how long you need to hold an asset.
• Your risk tolerance tells you the level of investment risk you can take. Based on this, you can be a conservative, a moderate or an aggressive investor.
• Year after year, the rates of return on various asset classes constantly change, depending on various microeconomic and macroeconomic factors. 
• This is why asset rebalancing is needed.
• It is the process by which you can restore your portfolio to its original target allocation. Rebalancing brings your portfolio back to the desired asset ratio. 
• You can do this by booking profits in outperforming assets and reinvesting those funds in the underperforming assets.