How much investment capital to allocate?

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Throughout our masterclass journey, we have delved into various topics covering the need to Angel Invest, Why not to Angel Invest, What to expect from Angel Investing & Opportunities it provides. We also covered in depth the Financial Terminologies that will assist investors in their Angel Investment journey.

In this Unit, we’ll cover Asset Allocation. We’ll look at how much an investor should allocate capital towards Angel Investing, understand the power of the law of returns, how many companies one needs to invest in & many such diverse topics that will assist an Investor in making the right investment decisions. Our first module discusses how much Investment Capital to allocate & what things to keep in mind while allocating.

Like always, we’ll start with a short story. Let’s Begin!

In the bustling world of investments, Sarah found herself at a crossroads, On the one hand, her job was paying her just enough to maintain her living standard while on the other hand, the inflation was rising and her income was not enough to cope with increasing expenses. Being an elder sister she had to look after her little brother’s expenses apart from paying off monthly expenses like Rent, Groceries, Electricity, etc.

One fine day while packing her bag after a long day’s shift, her friend walked up to her and inquired about how she was managing her expenses. Tension was very much visible on her face. The friend suggested she start investing whatever little she could & further diversify it to reduce risks. This way not only would she meet her future expenses adequately but also be able to secure her family’s future & meet her own financial aspirations.

Deliberating the crucial decision of how much capital to allocate for investments. Armed with financial wisdom from mentors and years of market observation, she embarked on a strategic journey.

Sarah understood the importance of diversification and risk management. Setting clear financial goals became her compass, guiding her allocation decisions. She decided to earmark a substantial portion for equities, seeking growth potential, while allocating a percentage to bonds to provide stability and minimize risk. Real estate investments offered a tangible and resilient asset class, securing another slice of her portfolio.

As market dynamics shifted, Sarah remained adaptable, tweaking her allocation strategy. She embraced the principle that no one-size-fits-all formula exists, recognizing the need for periodic reassessment.

Through disciplined decision-making, Sarah's portfolio flourished. The carefully balanced allocation not only weathered market fluctuations but also capitalized on emerging opportunities. Sarah's story reflects the art and science of investment allocation – a dynamic process where thoughtful decisions and adaptability pave the way for long-term financial prosperity.

Now let us come to the present day. In the past, our ancestors used to advise their successors to save 2/3rd of their earnings. In other words, if an individual was earning ₹100, they were asked to save approximately ~ ₹67 of that while the remaining ₹33 would be for consumption.

Today, things are much different than they were in the past. Today’s generation is much more risk-taking and has a lot of more secure investment avenues than the previous generations had. More importantly, there’s a lot more financial awareness among individuals. Many consulting firms have come up in recent years whose entire business model revolves around directing individuals' investments to help them earn good returns.

If we talk about the present scenario, individuals like to save anywhere between 33% to 50% of their earnings that align with their personal financial goals & remaining is spent on consumption.

Suppose an individual’s total income is ₹100, assuming Sarah’s monthly essential expenses ranging from Rent to Bills to Grocery consumes 50% of her income which leaves ₹50 as savings.

Assuming this ₹50 as a whole, the first thing they need to do is save for their short-term goals & long-term goals. Let’s first take a look at the Asset options that an individual has to invest in:

Her friend suggested that 25% of your savings should be diverted towards Private Companies and the remaining 75% should be allocated towards other asset classes like Gold, real Estate, Fixed Deposits, Bonds, Listed Stocks & Mutual Funds respectively.

Now let’s break down the allocation of this 75% that are allocated to Non-Private Stock asset classes.

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Now let’s understand the allocation process. Assuming Sarah’s annual savings amount to ₹2 Crores & she has ₹1 Crore of past savings. So now, we begin with the allocation process.

Let’s start with Gold. People in India consider gold to be an ornament rather than an investment. Infact as per recent estimates, Indian women account for 11% of the world's total gold reserves. This is about 18,000 tons of gold.

Real Estate Investments have also mostly given single-digit returns in the past decade. Although there are real estate investments that provide double-digit returns as well those are mostly limited to Tier 1 cities, and the cost of investment is often considered excessive. More importantly people in India like to prefer investments in real estate for their consumption i.e. for their living rather than looking at it from a pure profitability prism. Owning a house has become a statement of lifestyle now. Indian values lay importance on having a roof over your head is one of the top priority.

So the amount of savings an individual diverts toward these two assets depends on their returns-generating capability and your short-term and long-term goals. On average 2-5% of your investments should be in Gold & Real Estate.

Next, we turn to short-term goals. Short-term goals are generally considered as a period of up to 7 years. Supposing in another 2 years, Sarah plans to have a car or she plans to pay the college fee of her younger sibling in the next 5 years or Sarah plans to save something for her marriage over the next 7 years.

Sarah would look to invest in instruments or assets that give her fixed returns over a period of time. In this case, where she is planning to undertake a financial liability upon herself, she can invest in assets like Fixed Deposits, Bonds, or Non-convertible debentures & Debt/balanced type Mutual Funds that would pay her regular returns. Now this can also depend upon person to person. Planning for Kids or going on Extravagant/foreign trips on Honeymoon are other common financial goals that people have in their bucket lists.

Most people tend to put all of their savings towards Short-term goals and nothing is kept for the long term.

Assuming Sarah ends up diverting 40% of her savings toward these Short-term goals, she would be left with 60% of her remaining savings, out of which another 35% she can divert toward her Medium-term goals which can be related to family planning or planning your kids future or buying a house, etc.

Sarah being an avid investor would look to invest in Equity Funds and Mutual funds to plan to finance her Medium-term goals. Her friend suggested that for better returns, she might as well diversify her equity & mutual funds portfolio in such a way that it focuses more on the small-cap stocks and Sector sector-specific stocks that have higher growing potential. If she wants exceptional returns then Sarah might also invest in PMS where professional portfolio mangers would manage her investments. Disadvantages & Inherent Risks of Mutual Funds get covered in PMS.

This leaves 25% of investable savings with Sarah which she could divert towards investing in Private markets. Her friend suggested she adopt a disciplined approach when investing in Private Markets and don’t get carried away by outliers. In other words, if she has 25% savings diverted toward Private Markets, then in 4 years that sum will go up to 100%. Let’s consider this as ₹100 for ease.

Sarah can adopt a strategy where this ₹100 will be distributed among 20 companies over the next 4 years with each company getting approximately ~ 5% or ₹5 of savings.

Her friend also cautioned that if she invests in 20 companies, the probability of finding an outlier in 1 company is 60%. Outlier, in other words, means any company that gives you more than 10x returns. If she invests in 50 companies with each getting ₹2, then the probability of an outlier is 95% and it keeps on increasing.

So, if Sarah invests in 20 companies in the next 4 years, she’ll have to identify 5 such Private Companies every year from whom she can earn good returns & this would take it to 20 companies over 4 years.

Let’s assume Sarah right now has ₹1 crore as savings & she can save ₹50 Lakhs every year, in the next 5 years, her total savings would be ₹3.5 Cr. to invest in Private Companies. Even if she plans to invest it in 25 companies (5 companies per year), the per-company investment amount would come out to be roughly ₹14 lakhs. If Sarah plans to invest in 5 companies annually, then her annual investment in Private companies would come to ₹70 lakhs.

Let’s take another example. Suppose Sarah doesn’t have anything in savings and she can save ₹50 Lakhs per year for private markets, then total investment, over 5 years comes out to be ₹2.5 crores. Assuming she invests in 25 companies over 5 years i.e. 5 companies every year, then her annual investment would come out to be ₹50 lakhs with each company getting ₹10 Lakhs.

Take another example. For instance, Sarah had ₹1 Crore as past savings, and assuming she had the ability to save ₹50 Lakhs in the first year & every year her ability to save increased by ₹10 Lakhs. By the 5th year, she would have a total savings of ₹4.5 Crores. Keeping the number of companies the same i.e. 25, her annual investments would be ₹90 Lakhs with each company getting ₹18 Lakhs as an investment.

Take a fourth example where Sarah wants to increase her investment avenues and so she plans to double the number of opportunities. In other words, the number of companies increase to 50. In that case keeping everything else constant including ₹4.5 Cr as savings, the total annual investment would amount to ₹90 lakhs but the investment in were company would drop to ₹9 Lakhs.

Too many cases, right? Ultimately the amount of investment any individual makes depends on the savings they can generate.

The key here is to take small bets & average out the risks through diversification.

So what lessons do we learn from the above story?

Several valuable investment lessons emerge:

Strategic Diversification: Sarah understood the importance of spreading her investment capital across different asset classes.

This strategic diversification helped manage risk and capitalize on various market opportunities. Strategic diversification is the cornerstone of a resilient investment portfolio, involving the deliberate allocation of capital across a range of asset classes.

Clear Financial Goals: As we saw in the story, setting clear financial goals provided Sarah with a roadmap for her investment journey.

This clarity enabled her to align her allocation strategy with specific objectives, whether it be growth, stability, or a combination of both.

Continuous Assessment: Regular reassessment of her allocation strategy showcased the importance of ongoing evaluation.

Markets and personal circumstances change, and periodic reviews ensure that the investment portfolio remains aligned with evolving goals and market conditions.

In essence, the story emphasizes the art and science of investment, where a thoughtful, disciplined, and adaptable approach to capital allocation forms the foundation for long-term financial success.
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