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.
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||Justification|
|Very Large Caps (above $50 bn)||20%||Matured stocks tracked very extensively by analysts.|
|Large Caps ($10 bn to $50 bn)||40%||Large caps with still room to grow and create wealth.|
|Mid Caps ($2 bn to $10 bn)||30%||The next set of large caps with robust business models and delivering growth and margins.|
|Small Caps (Less than $2 bn)||10%||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.