What is Asset Allocation? Why are we discussing the asset allocation strategies? Because I do not want you to repeat the same mistakes I did. In 2008 crash my entire portfolio value was reduced by more than 60%. It did not consist of crap stocks( in fact I had more blue chip stocks) but still I lost lot of money.I thought I will be able to recoup it, but it took nearly 3 years to recover fully.
So why did I lose so much? It was because my entire portfolio was stocks. I did not diversify into other assets like gold, fixed deposits, bonds etc. I had “all eggs in one basket”. So when the basket falls, all the eggs are broken. If I had my eggs in different baskets(read :assets) then even if one basket performs bad, I have others to minimize the loss.
For an ordinary investor, asset allocation is of paramount importance. If you are ultra wealthy, then it’s a different scenario. But are you a person who earns by hard work, saves for goals, invests for retirement? Then do not forget asset allocation else you’re in for a rude shock.
What is asset allocation?
Asset allocation is nothing but an investment strategy. You balance your risk and reward by diversifying your money into various asset classes – gold, real estate, stocks, bonds, fixed income securities, arts. Each asset class has its own risk and rewards. You will decide the percentage to allocate to each asset based on your investment goals, risk tolerance and time horizon.
Importance of asset allocation?
A study by Kaplan found that 90% of your return from investments depend on your asset allocation and only 10% from market timing/stock selection. Yet, we all spend 90% of our time on choosing stocks and trying to time the market. Yes, they are important as well but not as important as asset allocation for individual investor.
If you’re investing for long term ie., 10 years or more, it doesn’t matter if you enter the Nifty at 6000 or 7000. It matters only if your horizon is 3 years or less. Consider this, each asset class performs well during a certain time period. Mehrab Irani in his book 10 Commandments of Financial Freedom describes this performance
- Interest Rates Peak,Bond Price Bottom,Credit Demand declines- The best asset performing class is Government Securities
- Central Bank Comes Into Action – Best performing asset is Corporate Bonds
- Equities bottom due to high interest rates – Best asset class is Equities
- Then Commodities bottom out – Best asset is Commodities like Gold, Realty
As an individual you must try to optimize your asset allocation. This makes sure that when one asset performs badly, the other asset compensates for the suboptimal performance.
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Optimizing asset allocation
So how do you optimize your asset allocation. Modern Portfolio theory explains optimizing asset allocation as “maximizing returns by investing different proportions in assets based on actual risk taken”. To put in simple terms- maximizing your return based on risk you take. You can’t expect high returns by taking low risk. Return possibility is directly proportional to the risk taken.
Equities have the highest risk and highest possible returns. Government bonds/fixed securities have lower risk and comparitively lower returns. Cash has no return and no risk(only inflation risk). This is a risk -return tradeoff. Once you decide how much risk you can take, your return varies accordingly. The goal with asset allocation optimization is to make sure you get maximum returns based on your risk. Check out the below graph
If you see in the chart, your portfolio must lie on the curve for optimized returns. This curve is called Capital Allocation Line. Harry Markowitz in Portfolio theory explains “A portfolio is said to be optimized/efficient if no other portfolio can provide a higher return for the same or lower risk”.
Related Wikipedia article(if you love complex equations): Capital Allocation line
If you note above, you will see that even for most conservative investor there must be some allocation to stocks. Stocks are best hedge against inflation. You ignore stocks at your own peril.
Asset Allocation Strategies
There are multitude of asset allocation strategies available. Some of them are listed below
- Strategic Asset Allocation
- Tactical Asset Allocation
- Dynamic Asset Allocation
- Insured Asset Allocation
- Integrated Asset Allocation
- Constant-Weighting Asset Allocation
Going into the asset allocation strategies is more theoretical. It is not easy for ordinary investors to understand and implement them easily. So I decided not to go into detail on this topic. Rather, I present my more simplified version below so that a common man can understand. However if you are really interested technically check out this Investopedia article on Asset Allocation Strategies
How to build a profitable portfolio
As I said above, a good portfolio of a common investor must consist of different assets. Let us see the step-by-step approach to build a portfolio for oneself
Step 1: Decide how much risk you can take
This is the most important step in deciding asset allocation. Each individual is different. His goals and responsibilities are different. If you are young, then you can take more risk. However, if you are a family man your risk taking ability is constrained. If you’re about to retire then I advice you take minimum risk as possible.
- What’re your expenses – Family expenses, Routine expenses like rent,car, education, medical. How much is left to save each month
- How much you owe – Your loan outgoing, principal pending, rate of interest of loan
- Your age – Most important factor. As it decides how long you’ll have income
- Your income sources – Are you sole earning member? Does your spouse earn? you have assets/investments which add to monthly income? How stable is the income?
Based on these, you can determine how much risk you can take. This will give a fair idea and sets you up for the asset allocation strategy
Suggested Read: ‘Mis-selling’- Why you should not believe your advisor sometimes
Step 2: Clarify the purpose of your investment and its importance
The next step once your risk is determined is the purpose. Why are you planning the investment. What for? You may plan for variety for reasons. Some are
- Retirement planning – Saving corpus for retirement and medical aid in future
- Children education – You may want to invest for sending child to best schools or foreign study
- Marriage expenses – You may love a fancy wedding for you or your kid (After it is indispensable and a prestige matter in India )
- Miscellaneous goals – A foreign trip, luxury car, vacation home etc.,
Once you have clarity of purpose it determines the importance. For eg.m retirement planning, child’s education-marriage are very important. You can’t neglect them. But, you can postpone a foreign trip or luxury car.
Step 3: Quantify the exact amount needed and time horizon
There is no use if you do not know exactly how much and when you will need the money. If not, It is like shooting in the dark. You need to know the target to shoot at. How much does it cost now? What will be the cost in future? How much later you need – time horizon.
For eg., your kid is 8 years now. You may want to send him to Engineering college. The cost of entire engineering course is approximately Rs. 6,00,000 now. Assuming your kid goes to college at 18 years , your investment horizon is 10 years. He will need Rs 18.6 lakhs at that time considering 12% education inflation. So plan accordingly based on how much you can set aside each month. Else you will fall short of needed amount.
Use our FREE Inflation Calculator to estimate how much you will need in future.
Related reading : What is inflation and how inflation affects you
Step 4: Build the portfolio
Once you have clarity of purpose, quantified the amount needed, estimated your time horizon, determined your risk tolerance now build a portfolio. The above factors will determine if you must take a conservative or aggressive approach. Be rational in your expectations. You can’t build a large portfolio making small investments and taking minimal risks in short time. If you need more money, your time horizon must be long or risk must be more.
The main goal here is to protect the value. A conservative portfolio will consists of more than 60% in fixed income securities. Best suited if you can make substantial investments and accept lower returns. This is for highly important goals like education or marriage where you can’t jeopardize the purpose for any reason
The main goal here is maximum return, It will consider mainly of stocks, real estate and high risk assets. best suited when your time horizon is less and you need to build portfolio fast. The risk also is considerably higher as it combines capital growth and regular income.
Step 5: Periodically assess and re-balance portfolio
Once your portfolio is built, you need to assess it often. By often, I do not mean every day/week. A yearly or bi-yearly assessment should be more than enough. Why do we need to re-balance? The value of one of asset class will shoot up in a particular time. So your portfolio will be skewed more towards one asset class. By re-balancing you’re reducing the risk and optimizing the portfolio.
For eg., if you had Rs.1,00,000 portfolio with 75,000 stocks+25,000 bonds. After 6 months if market performs 20%, stocks will be worth 90,000 and bonds will be 26,250(assuming 10%p.a). So your stocks are nearly 78%. If your ideal is 75% stocks, then sell Rs.2700 approx worth stocks and put in bonds to achieve ideal percentage. Discipline is the key.
Conclusion: Asset allocation is your key to long-term wealth creation. Don’t put all eggs in one basket if you’re an ordinary investor. It protects you from vagaries of market/assets over time and protects wealth generated. Build a portfolio using the above approach and achieve your cherished goals.
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