2. One
ASSET ALLOCATION
Raakesh V Thayyil
What is Asset Allocation?
Asset allocation means diversifying ones money among
different investment vehicles, such as stocks, bonds, bullion, real
estate, money market instruments, etc. The goal is to help reduce
risk and enhance returns by asset diversification – the correlation
between different asset classes is not likely to be high i.e. the
likelihood of all asset classes rising or falling at the same time is
expected to be low. Establishing a well-diversified portfolio allows
one to avoid the risks associated with any one asset category. Every
investment option has different characteristics, behaviour, returns,
risk and usage. As ones financial goals are diverse, so should the
investment choices be.
Investors believe timing the market is the key to successful
investing; though this rarely works in reality, as it is near
impossible to accurately predict the market level at any given time.
Others think that only picking the right stocks/ bonds, sticking
solely to government small saving schemes or real estate is the
ideal investment. Asset allocation combined with systematic/
periodic investment is a low-cost and easy to implement strategy,
which ensures market linked returns with reduced risk.
3. Two
Why use Asset Allocation?
No single investment is likely to meet all of one’s needs, so
depending on one’s age, lifestyle, family commitments, level of
income and expenses; the financial goals vary. In order to assess
our needs, we have to define the investment objectives, which
could be receiving a regular income, buying a house, financing a
wedding, paying for ones children’s education, or it could even be a
combination of some or all of these. Note that each of these goals
will have different time periods for fulfilment.
Besides defining ones objectives, you also need to take into
consideration the amount of risk you are willing to take or can
tolerate and what ones cash flow requirements are. This is basically
Financial Planning, which is covered in a separate article in this
issue. The concept of asset allocation is closely linked to a concept
called Life Stage (Cycle) Planning.
Life Stage Planning
Life cycle planning is to put it simply, choosing your
investment to match your stage in life. The progressive change of
seasons is analogous to the cycle of one’s life. Throughout life, one
encounters many changes, such as marriage, children, buying a
home, financing children’s education and marriage, and even caring
for ageing parents. All these situations put a strain on our finances.
Hence, it’s important to set goals and follow a financial plan tailored
for your requirements. We may divide life stages into the following
six common Life Cycle cases: -
- Case 1 Single & working without dependents
4. Three
- Case 2 Single & working WITH dependents
- Case 3 Married without children
- Case 4 Married with children
- Case 5 Nearing Retirement
- Case 6 Retired
How to go about Asset Allocation?
First, one should keep three–six months expenses (including
all sundry expenses and loan outflows) in an emergency reserve
fund, to meet any urgent needs.
This fund should be in the form of cash, bank deposits and other
liquid deposits/ schemes such as liquid mutual funds. Next comes
the actual planning of allocation.
As per your age and situation, decide the allocation (in
percentage) between investment classes such as equity, debt,
savings, provident fund, gold, property, insurance, cash, liquid
funds, etc. Each of these asset classes has distinct & correlated
(marginal or significant) properties; the mix-n-match should cater
for this as well as your risk profile. If you are not interested in the
theory, merely use the Risk Profiler uploaded at
http://www.scribd.com/doc/14074747/Risk-Profiler. The aim is to
diversify risk across investment tools.
5. Four
Portfolio Rebalancing - This requires periodic
realignment (preferably half-yearly/ yearly) to maintain your
preferred allocation. The allocation itself needs to be reviewed
every 5 years or on occurrence of major events such as birth,
death, education, marriage, etc.
As you approach (1-3 years apriori, depending on their
importance) your planned time horizon for retirement, marriage or
education of children etc., you should gradually and progressively
move the funds into more secure (and less risky) investments. This
is to protect against a notional loss when you actually need the
funds.
No matter what your plan or savings programme, it is
important to evaluate your portfolio. As major changes occur in life,
see if your present allocation is suitable; else readjust the allocation
plan to one’s stage of life and investment goals.
At the very least, reassess your plan every six months; to
gauge your progress or realignment needed. With the strategy of
asset allocation, you’ll be able to keep the investment plan on track
to successfully meet all your planned requirements.
Generalised Investment Strategies
I’ve included three common investment plans to suit most
requirements and given appropriate suggestions; which are general
indications and will vary depending on your risk appetitive, present
assets & investments, income, cash flow, holding period,
dependents and other variables. But you can use these to tailor a
plan for yourself – mix and match as per your requirement.
6. Five
Aggressive Portfolio
In an aggressive growth portfolio, 60% - 70% of total assets
may be allocated to equity (stocks or equity mutual funds), 10% -
30% in fixed income securities (bonds or debt mutual funds), 5% in
gold (gold ETF’s or commodity funds), 0% - 10% in short–term
options (bank deposits, liquid funds, short-term money-market
instruments and debt mutual funds) and 5% in cash (or cash
equivalents, if required).
This portfolio is recommended for those in the 1st
or 2nd
cases.
Those without dependents may even increase their equity portion
and is newly independent financially, it takes a lot of discipline to
save & invest. Early in ones career, retirement is a long way off.
Aggressive Asset Allocation
The younger you are the greater is the ability to withstand
risk. The equity part of the portfolio is meant for capital growth to
meet longer-term goals while the bond portfolio is to provide for
medium-term needs.
Thayyil’s Aggressive Allocation
7. Six
Moderate Portfolio
A moderate growth portfolio seeks to balance growth and
stability; having around 30% - 50% in equity, 40% - 50 % in fixed
income securities, 5% in gold, 5% - 15% in short –term options and
5% in cash or cash equivalents.
This portfolio would seek to provide regular income with
moderate protection against inflation. The equity component has
growth potential, whereas the bonds and short-term instruments
help balance out fluctuations. Education and other such needs could
be met from the bond portfolio, while you continue to invest in
equity for your retirement some years away.
Moderate Asset Allocation
This portfolio is suited for the 4th
case – case 3 individuals
may flip the equity & bond ratios; and is ideal for those in their
peak earning years, and having to finance children’s education. With
retirement getting closer, it is also time to re-evaluate ones goals.
Is your retirement nest egg where you want it to be at this stage in
your life; if not, will you have time to work on it?
Thayyil’s Moderate Allocation
8. Seven
Conservative Portfolio
The allocation suggested is 15% - 25% in equity, 50% - 70 %
in fixed income, 5% in gold, 5% - 15% in short –term funds, and
5% in cash (if needed).
Conservative Asset Allocation
This is ideal for those who are nearing retirement or have
already retired. This investment strategy would aim to keep ones
savings secure, while at the same time generating enough income
to help you relax and enjoy your retirement years. Moreover, since
sources of income after retirement may be limited, savings would
need to go a long way. And the 15% - 25% (5% - 10% after
retirement) equity portfolio will assist you in staying ahead of
inflation. As retirement nears, shift funds out of risky assets into
stable ones.
Thayyil’s Conservative Allocation
9. Eight
Conclusion
From the foregoing, the importance of asset allocation and
financial planning must have be apparent; nevertheless the same
cannot be over-emphasised, especially with galloping inflation in the
important education and health sectors; far out-stripping the
already high levels of consumer inflation.
One needs to note, that a very important aspect of financial
planning has been left out i.e. Insurance; as the primary role of
Insurance is Risk-Coverage and not investment. Insurance should
be taken using a Term plan or an Endowment plan; avoiding the
popular and expensive Money-back plans & ULIPs. Go in for a
combination of a Term plan and MF’s to replicate an ULIP more
efficiently. If you have an ULIP, hold/ contribute to it for at least 10
years to derive value from it – the insurance company having
already leached its costs over the first three years.
