Asset Allocation- The key to success of financial planning

Asset Allocation- The key to success of financial planning

The continuous fall in the rupee does not augur well for the economy. Neither does the skyrocketing onion prices and rising inflationary concerns brings any relief to consumers. Such news only leaves us to wonder whether our investments would pay off or not.  From stock market crash in 2008 to the current crash in the bond prices, investors should learn not to be swayed by market sentiments. The thrust should be on proper financial planning backed by adequate asset allocation. Asset allocation assumes much significance in times where there is volatility across all asset classes, be it equity, debt or gold.

The idea behind investments is to put money in a medium that can generate reasonable income without minimal interference and at the same time keeping in mind your risk appetite.  But to achieve a desired financial goal and minimize risk you have to ensure proper asset allocation.

Let’s see what asset allocation is and analyze its importance. Asset allocation simply means the practice of investing money systematically across a basket of assets to ensure if one doesn’t work the other balances out the overall portfolio.  In addition to the three main asset classes like equities, fixed-income and cash equivalents (money market instruments) real estate and commodities, mostly precious metals like gold and silver can also be added. Normally as an investor you would put some money in equities either through direct equity investment or equity mutual funds (MFs), some in small saving instruments, some in bank fixed deposits (FDs) and some in gold. This means you ideally spread your investments across different income- or return-generating instruments which are known as asset allocation. You invest with an aim to achieve returns or fulfill your financial goals but you might not reap the desired benefit if you don’t choose the right kind of asset.

Helps to attain a financial goal: If you have a particular goal in the future then the same can be achieved with more certainty by following a proper asset allocation plan.

For example if you want a corpus of Rs40 lakh for your child’s professional education, 15 years from now and you start investing Rs. 10000 per month in the ratio of 60:30:10 in Equity, Debt and Gold you will be able to accumulate around Rs. 24.41 lakh in next 11 year if equity grows at compounded annual growth rate of 12%, Debt at 8% and gold 10% . Now at this point of time if you want to reduce your equity exposure to avoid risk of market volatility you can rebalance your existing portfolio and also redirect all future investments in the ratio of 15:75:10 in equity, debt and gold for next four years to accumulate the desired corpus.

Similarly allocating entirely to debt will not get you the desired corpus at the end of the tenure. For instance if you invest entire Rs 10000 per month only in fixed income instrument like recurring deposit which gives 8% annual return you will be able to accumulate only Rs. 34 lakh in 15 years. Hence, instead of one asset you have to consider a basket of assets to balance risk and return.

It is generally observed that market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category which are negatively correlated, you’ll reduce the risk that you’ll lose money and your portfolio’s overall investment returns will have a smoother ride.

Let’s consider an example to see how asset allocation helps to reduce risk.

Minimizing risk, maximizing returns:You should follow the old adage while investing like don’t put all your eggs in one basket. It could be risky to invest all your money in one asset class. Let’s consider investment in equity over a longer period, say, 10 years, equities have the potential to deliver 10-15% CAGR; in shorter periods, returns can be volatile.

If you had invested Rs  1 Lakh in an Equity Index Fund on 1st January 2008  when Nifty opened at 6137 the value of your portfolio had been only Rs. 93567 on 31st July 2013 down by 6.43% as Nifty closed at 5742 that day but if you had followed asset allocation strategy and invested Rs. 50000 in Equity, 25000 in Fixed Deposits and 25000 in Gold on 1st January 2008 the value of your portfolio could be Rs. 146009 on 31st July 2013 up by 46% as gold appreciated by 143% during this period.

You can clearly make out from the above example how asset allocation can helps limits losses when returns are falling. Since it is impossible to know in advance how the market will move, it’s prudent to have your surplus spread across different assets and balance risk and return.

Bond market also take a hit:According to news report, the sharp slide in the value of the rupee wrecked havoc in bond markets in June where gilt prices fell sharply anticipating a selloff by foreign institutional investors.  The fall in bond prices was so sharp that it triggered off circuit filters forcing a halt in trading. Then the bond market crashed in July with the 10-year government securities (G-Sec) yield surging 50 basis points (bps) to trade at over 8 per cent. The crash in bond prices comes after the Reserve Bank of India (RBI) raised the cost of borrowing (marginal standing facility) for banks. This is the first time since 2008 that the yields have jumped 50 basis points in a single day.

Now that you know why choosing one type of asset could ruin your chances of positive returns you should go with proper asset allocation plan. The next step is to consider the factors for allocation in different asset classes. What are the few things to consider while deciding the percentage of allocation?

Goal-oriented asset allocation:You should start by evaluating your financial objectives at different age. You should set your short term, medium term and long term goals. The objectives should be in terms of priority and evaluate the corpus you would require for each goal. The idea is to try matching the right kind of assets to every goal; each goal can have its own asset allocation. For goals that are a year or two away—say, buying a car or going on a foreign holiday—it makes sense to preserve capital and go for debt investment options. Taking too much exposure to equity in the short term may be extremely risky.

Consider your risk appetite: Also the level of risk will differ for each individual. Your willingness to accept a level of risk doesn’t mean it’s appropriate for you. For example, if bulk of your financial objectives mature in two years, including paying for your child’s higher education, relying on only equity may not be suitable as the period is too short to expect equities to deliver the desired returns; you’d rather look towards debt investment options.

Age also comes into play:Every investor can stomach risks to an extent and it is important to ascertain how much risk you can take at a particular age. Your equity allocation, for instance, would be lower if you are a senior citizen, retired and seek a regular income. But if you’re young and salaried and retirement is years away, typically, you would be willing to take additional risk to build a tidy retirement corpus.

Lastly, you have to pick the right products within each asset class to address your needs and this too is relevant to your overall risk profile. You also have to rebalance the asset allocation at a suitable frequency so that you are able to stay on course with your goals.  With these few things in mind and proper asset allocation you can ensure a worry free investment for yourself.

About the Author

Pankaj Mathpal

Pankaj Mathpal, Founder and Managing Director, Optima Money Managers Pvt. Ltd. has over 22 years of work experience in Marketing, Financial Planning & Education. Read More…