The asset allocation decision is a function of your risk tolerance, return needs (whether you need to emphasize on current income or future growth), and your investment time horizon. When one of these conditions changes, it is time to reconsider your asset allocation.

When are changes likely to occur?

Individuals differ, and conditions may change simply because you have changed—for instance, you may get tired of volatile changes in your portfolio value and become more risk averse. Often, however, changes in these conditions coincide with major alterations in your life, in particular retirement; asset allocation can be viewed as a function of your life cycle.

Below are some of the major conditions affecting asset allocation decisions, and how they may change over time.

Risk Tolerance

Risk tolerance is not necessarily a function of age; a conservative investor will go through changes in asset allocation over his life cycle, as will an aggressive investor. Risk refers to the volatility of your portfolio’s value. The amount of risk you are willing to take on, is an extremely important factor. Investors who take on too much risk usually panic when confronted with unexpected losses and abandon their investment plans mid-stream at the worst possible time.

Return needs

Return needs vary from investor to investor. Most younger investors who are accumulating savings will want returns that tend to emphasize on growth and higher total returns. Retirees on the other hand want returns that emphasize relatively on higher and consistent annual payouts. Of course, many individuals may want a blending of the two—some current income, but also some growth.

Investment time horizon

Your time horizon starts when your investment portfolio is implemented and ends when you need to take the money out. The length of time you will be invested is important because it can directly affect your ability to reduce risk. Time horizons tend to vary over your life cycle. Younger investors who are only accumulating savings for retirement have long time horizons, and no real liquidity needs except for short-term emergencies. However, younger investors who are also saving for a specific event, such as the purchase of a house or a child’s education, may have greater liquidity needs. Similarly, investors who are planning to retire, and those who are in retirement and living off of their investment income, have greater liquidity needs.

Changes Over Your Life Cycle

Let us take an example to show how major changes in an investor's life affects his asset allocation. The table below shows the changing allocations for two individuals over their lifetime: one, a more conservative investor, and the other a more aggressive investor.

Let us consider that these two investors start at the same stage in life. The conservative investor has a 65% commitment to equities, primarily in the more conservative large-cap sector; the aggressive investor with a 85% commitment to equities, evenly split among the large-cap, and small-cap segments. Their responses to major changes over their life cycle reflected by their asset allocations, however, are similar.

To begin with, both investors have at least a 15% commitment to cash at all points in their life cycle, reflecting the need of all investors for some liquidity for short-term emergencies. In addition, both investors in the table have at least a 50% commitment to equities at all points in their life cycle, reflecting the need of most investors for some exposure to growth. Some individuals may view a 50% commitment to stocks as being not particularly conservative for a retiree; let us consider the allocations here as not recommendations, but simply examples. Let us keep in mind, however, that even retirees need to protect their future income from declines in purchasing power due to inflation.

Over time, as their income and liquidity needs increase, both investors increase their commitments to bonds and cash. In addition, both investors decrease their commitments to the more volatile segments of the equity markets—small-cap stocks—for more stability and for greater emphasis on the dividend-paying portion of the stock market. However, both investors keep at least a small portion of their portfolios committed to the small-cap stock market segments for diversification in the equity markets.

Of course, other changes in life could cause an investor to move from one stage to another. For instance, a married person with no children and who consider himself an aggressive investor, may turn more risk-averse when he has a child. Or a retiree may win Rs 100 Lakhs in a lottery and not have to worry any longer about living off of retirement savings. In addition, changes in your life may not necessarily cause a change in the conditions affecting your asset allocation decision. For instance, an investor with a large portfolio may not need to increase current income during retirement, and his asset allocation may very likely remain the same as that in his early career stage.