Making Smart Asset Allocation with Smart Layers

Many investors who are so called themselves as ‘aggressive’ putting all their money into shares and hoping to make it BIG. On the other hand, there are investors who are so afraid of equity that they tend to invest a few hundred lakhs of rupees fixed deposits and a tiny amount in equity. In nutshell, neither of them may be doing the prudent thing and are clueless even about the basics of ‘Asset Allocation’ owing to indifferent to the mix of assets. ‘Asset Allocation’ is a much familiar and frequently used term in personal financial planning. It simply means how much your investible surplus allocates to different categories of assets such as the choices range from the obvious stocks, bonds and gold to the more exotic commodities, real estate and derivatives is the crucial part of building a portfolio. The chief function of your asset allocation strategy should be ultimately ended up giving you to optimize returns in both bull and bear phase of markets. In other words, asset allocation is the simple task of deciding the mix of investments that suits your requirements the best and could able to fill the gap in your investment portfolio in turmoil period. This cobra post illuminates you to how to make smart allocation with layers.

Hit and Trial Method

Often, a famous notion among investors and even by many financial advisors is that your age should determine your asset allocation. It goes a shortcut like this as your percentage of ‘allocation’ to equity should have in your portfolio must be equal to 100 minus your age. For instance, if your- age is, say 30, you should be investing 70% (100-30=70) of your portfolio in equities. It is so convenient and too simplistic, if you go by this rule, you would holding just 40% in equities at the age 60 whereas you should have more focus on preserving your capital rather than you letting go of the wealth-building power that can allow you to live a comfortably long retirement. Age should not be the only factor in deciding asset allocation. After all, people of the same age can have different goals, income needs and expectations. Hence, this approach may be proven as illogical and over-simplified.

Understand your Risk Capacity

Each one of us has a different level and capacity for taking risks. And, we should also recognize that some degree of risk is a necessary part of successful investing, neither more nor less. Risk is worked as the oxygen of our investment portfolio. It’s an essential element for a portfolio to breathe and grow. The problem is that fires need also oxygen. Too much risk, however, can feed the flames of a reckless portfolio that then crashes and burns. Often, I have seen almost investors always overstate their ability to withstand risk in a bull market. They are much less willing to accept risk in bear market because the memories of being bitten are too fresh. One more interesting example came into the light me as one of the my clients, his risk tolerance had changed from aggressive to conservative with the death of his father even though his portfolio was unaffected. Of course, your risk-taking ability would keep changing with your personal as well as financial circumstances. It’s a psychological and social necessity.

Make reasonable Assumptions

Any approach to financial planning is to understand your present situation and make a reasonable assumption on ‘returns’ from different asset classes, rate of inflation, future growth of income, your defined commitments such as children’s education, retirement, events, etc. and your aspirations such as buy a bigger house, holiday plans etc. You have to start with a sense of setting a goal and approach it with the resources you have. For instance, if you have aspiration to accumulate Rs 2 lakh at the end of 12 months from today and all you have only Rs 1 lakh, the only way to meet your aspiration is to look for an investment that will double in year, the ‘return’ assumption will be unrealistic and flawed in your investment portfolio.

Adversity of Skewed Portfolio

Everybody’s situation is unique and, hence, demands a different strategy. But no matter what you do, the key thing to understand is that proper asset allocation reduces risk and increases returns. It may ‘maximize’ your returns but fetches you a return which is ‘good enough’ for the level of risk that you take. Once you are aware of the risks, you will have an idea of how much you could put in each asset class. For instance, at the beginning, you would like to put away the money to the maximum possible in public provident fund (PPF) for Rs 1 lakh a year for 30 years, your wealth would grow to over Rs 1.20 crore.  A fixed earning you 8% coupled with a 10% effective inflation rate will result in an erosion of wealth at the rate of 2%, annually, for the urban masses.

On the other side, if you take investment in equities, the long-term returns could be in a range of, say 12%-18% per annum. In other words, if you are able to save only Rs 10,000 per month for 30 years, the end number could be between Rs 3.08 crore and Rs 10.40 crore. And, at the precise end of the 30^th year, can you know what the stock markets would be like? It could be in a bull phase, bear phase or come off a top or bottom. So, all the assumptions in returns could go for a toss. Unfortunately, both the safe-saver and the risk- taker can end up with equally undesirable outcomes.

The same is case for all other assets such as Real estate has been good for some and bad for others. Gold was a hot favourite five years ago, but is hated now. The same goes for every asset class where market forces are at work.  So, it is rather difficult to align a specific goal to any one specific asset class. You have to understand the characteristics of every asset into which you are going to put your money. The idea is not to scare you; but to make you aware of what the implications could be. For example, in real estate, there are stories of properties where liquidity is close to zero, even at the prices you paid for! What is the meaning of returns, if you can’t sell something easily for a price you think you can get?

Layers of Asset Classes

If you are investing for the short term, save in an asset class where there is least risk to the principal. This may push us to anything from liquid funds to tax-free bonds. Here again, depending on the well-being of our economy, interest rates could change. So, there is uncertainty everywhere. The lowest-risk option would be bank deposits. On the other hand, for the longer term, uncertainty should not translate into fear and erode our wealth by keeping everything in the bank. To my mind, the highest returns are from equities, over a long-term horizon. So, after PPF, I would head to equities, as early in my life as possible. Perhaps, I would add balance funds as the first layer, then a diversified large-cap mutual fund scheme and then a mid-cap scheme, direct equities, etc. Thus, each subsequent allocation becomes a function of our circumstances and risk appetite. Risk changes with time, depending on how commitments move in life.

To sum up: first, understand where you stand. Build your financial safety that will give you peace of mind first. Goals have to be realigned in life, depending on how your investments fare over time and what are the circumstances when you actually need the money.

PS: This article got published in Hindi Dainik Bhaskar on 18-10-2016

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