Learning Asset Allocation

WEALTH CREATION : LEARNING ASSET ALLOCATION

Asset allocation is simply the decision you take, of how much of  your overall financial wealth should be in stocks (equity), bonds (debt) or maintained in cash equivalents (very short term bonds) and FDs.

This is one decision on which most financial advisors place a lot of emphasis. Bad investment decisions, it is said, arise mostly from bad asset allocation. If, as investors, we get the asset allocation decision right, then we greatly reduce the chances of our investments turning bad.

Perspective

So how much of your investments should be in equity, how much in bonds and how much in cash equivalents & FDs? The answer is unique to every investor, and depends on his or her unique situation.

However there are three guidelines you can use to understand how to make the asset allocation decision:

1. The more volatile the asset is in the short term, the better it will deliver in the long term. Stocks deliver the best average returns ever the long term, but also fluctuate the most over the short term. In contrast, bonds and money markers tend to have smaller fluctuations, but deliver lower returns over the long-term Thus, the time horizon - the length of time you are willing to invest your money- is an important factor in deciding your asset allocation. The longer you are willing to invest a portion of your money, the greater the allocation towards diversified equity for that portion.

2. While you may be comfortable staying invested for reasonable periods of time, you may not be comfortable with big fluctuations in the value of your portfolio. Or, while your commitment at the moment is for the long term, unforeseen contingencies may force you to terminate a part of your investment much sooner. Under such circumstances, your allocation to diversified equity may be lower than that warranted by the time horizon consideration alone. This consideration is usually labelled 'risk appetite' - which is a fairly ridiculous label, as nobody wants to go out and aggressively lose money. A better term which we will use here is ‘absorption capacity’.

3. Last but not the least, your asset allocation has to be governed by your investment expectation - how much you want your money to grow. If you need to double your money in 5 years, you would need a growth of around 15% pa. This cannot be attained without significant equity exposure in your investment portfolio. If your absorption capacity is lower, you would need to think in terms of either setting lower growth goals or planning for a longer time horizon to mitigate fluctuations. A quick snapshot of different assets one can invest in The chart below shows the various options within each of these asset classes.

Investment Options

   Equity

   Stocks

   Equity

   Mutual Funds

   Debt

   Government Bonds

   Banks/FIs FDs/Bonds

   Corporate Debt FDs

   Debt Mutual Funds

   Cash

   Liquid Money Market Funds

   Bank Savings

Your investment strategy has to begin with an objective analysis of what you want your money to do for you and take into account your personal preferences, your expectations and the time horizon you have decided on for your investments. We hope this gives you an understanding into making asset allocation decisions solely using returns as a means to an end. Remember: Allocation depends on several interlinked factors that are age, income, wealth, risk appetite and liquidity preference. This makes it difficult to make a precise allocation decision that can be used as a model by every investor.

Products for Various Life Stages

 Various Life Stages, What should be Your Approach and Allocation

For Young & single

1. Invest maximum in growth assets such as direct equities, equity mutual funds.

2. Ideal allocation could be: 80% in equity, 10% in fixed income, 10% in cash.

3. Buy a health insurance cover for yourself and parents.

4. Start saving and investing towards specific goals like marriage, purchase of house etc.

 Newly married

1. Build up an adequate emergency fund by investing in Liquid Mutual Fund schemes.

2. Ideal allocation could be: 80% in equity, 10% in fixed income, 10% in cash.

3. Start investing in Retirement plans

4. Get an adequate life cover. Include wife in family floater health cover. Pay insurance premiums regularly.

5. Plan for paying off the loan at the earliest.

Starting a family

1. Start saving for children's education and marriage.

2. Ideal allocation could be: 70% in equity, 20% in fixed income, 10% in cash.

3. Include children in health insurance cover.

4. Plan for paying off the loans at the earliest.

 Grown-up children

1. Buy critical illness cover for self and wife.

2. Adopt a balanced approach.

3. Ideal allocation could be 60% in equity, 30% in fixed income, 10% in cash.

4. Plan for paying off the loans at the earliest.

Retired

1. Ensure adequate health insurance.

2. Enhance protection with a fund allocated for emergency requirements.

3. Focus on safety, however you can't avoid equity.

4. Your ideal allocation can be : 20% in equity, 70% in fixed income, 10% in cash.

The Ideal allocation given in the table above are given for general reference, it may differ for any given individual depending on individual circumstances and aspirations.

Happy Investing!