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Opinion

Why Asset Allocation Deserves More Attention

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When I initially started investing, which is not very long ago, I saw a lot of platforms with goal plans and “risk assessment”.

A novice investor does not understand risk all that well. What I WANT to do in terms of investing and risk taking can be very different from what I CAN or SHOULD do.

Still, we go ahead and answer the “risk assessment” questionnaire as per our current mood.

If you have recently received gyaan from a  friend who explained how “you should be taking more risk” and that “doing so can give you better returns” etc, it is possible that the effect of this will percolate onto how you answer the questions.

Meaning, because you heard this gyaan, you “feel” like taking more risk because hey, what am I doing with my life otherwise. And you answer like you can put all your money into heavily risky investments. Or because someone you know recently lost money in stocks, you don’t want risk at all.

Your recent experience in the stock market may also dictate your attitude towards risk. So can your parents, spouse and dog. Your risk taking “self assessment” is really that vulnerable.

This vulnerability has an adverse affect on how your funds gets allocated over time vs how they should be allocated with respect to where you want or need to be.

So after five years, you may find yourself fully invested in one asset class only (equity, debt, real estate, gold?) With over exposure to one asset class that makes you uncomfortable.

Or you realise that even though your original answers have changed, your portfolio allocation has not. You started with 30% in equity and you still have 30% in equity. When you CAN easily take more risk. And you WANT that too.

This is because most risk assessment is done without understanding how you are currently invested, the asset classes you already have exposure to the quantum of your investments, your life and income situation etc.

Each time you take a recommendation; it is as fresh as a daisy with no regards to your current financial situation or exposures.

(For example: A 25 year old will be told to invest any money heavily in risky equity even if she has huge education loans to pay back, a family to support and pay for two siblings’ education. Even if she already has most of her savings in equity already.)

And so you end up with a grossly mis-allocated portfolio that is giving you more worry than what it was supposed to solve.

The problem is that most of the advice for retail investors is product focused, instead of being strategy focused.

Which mutual fund to buy is a product focus.

The overall allocation, how much to buy in each asset class – equity, debt, gold, cash – is a strategy focus.

The better strategy is Asset Allocation

Asset allocation is a modern portfolio strategy that attempts to balance risk versus reward by distributing the portfolio among different asset classes.

The definition we all read but rarely understand.

I know I’ve lost you at “asset class”. But stay on, it gets better.

So let us try to understand it the other way round.

Once, there was a woman. She had a dairy and a golden hen. Each time the hen laid eggs, the woman would carry them in a basket, cross the river on foot and sell in the market that was set up on the shore every Saturday.

One day the hen laid 5 eggs.

As she always did, the woman put all the eggs in her basket and started crossing the river. As “luck” would have it, she stumbled, fell in the river and broke all her eggs.

That day she prophesied – “don’t put all your eggs in one basket”.

If you don’t believe my story, tell me why else would anyone say something like that!

The next time the hen laid eggs, woman bought five baskets. She put one egg in each basket.

1st one she gave to her sister to carry in a boat

2nd one she gave to her daughter to tie on her back and swim through

3rd, 4th and 5th one she, her husband and son each carried with them while crossing the river by foot.

She distributed her risk and increased the probability of better returns.

An extreme disturbance in river can be a scenario where all of them get affected and break the eggs. That’s an environmental factor, not in their control.

It is the same with investing. What is not in your control is Risk. What is in your control is managing that risk by hedging your bets. The better you manage risk, more is the probability for return.

Asset allocation, deciding which asset class will hold what percentage of your portfolio, is the strategy you want to focus on.

So what’s the risk?

In investing, there are risks aplenty. The broad categories are :

  1. Business Risk : When you invest your money in equity or debt, you invest in a business. The business has either raised money by issuing stocks(equity) or borrowed money by issuing bonds (debt). The risk you take is the uncertainty of how the company will perform and survive at least till it is payout time for you.
  2. Inflation Risk : Inflation reduces the purchasing power of money, which is a risk you and I as investors have on returns we get from fixed income instruments.
  3. Interest Rate Risk : Bonds have inherent Interest Rate risk. The higher interest rate lures investors to invest in new bonds (issued at this higher rate) while those invested in bonds at lower rates will sell their holdings at a discount to be at par with the prevailing market rates.
  4. Volatility Risk : This is a combination of internal and environmental factors. A stock may experience volatility because of change in management, performance of products, dip in earnings etc. It also experiences volatility due to political or market events. The volatile nature of stocks make them risky in the short term. In long term these fluctuations tend to even out, in most cases.
  5. Liquidity Risk : A risk that you may not be able to liquidate your investment when you need the money. One requirement is to have access to your money when you need it. Else, is it worth earning attractive unrealised gains when you cannot en-cash and realise it when needed (it can be, but you should think about it)

 

The economic, political, social and internal environment exposes the different asset classes to these risks. However, it is rare that a stimulus will have a similar effect on all asset classes.

For example, an interest rate risk affects bonds(debt) more than stocks(equity).

That’s where the concept of asset allocation gains its streng Ath.

When you allocate your investments to different asset classes, you mitigate risk by increasing the probability of making gains elsewhere (or comparatively lesser losses).

But how to decide how much to allocate to each asset class?

The allocation that’s best for you at any point in time depends on two factors – the time horizon and risk tolerance.

Time horizon is the time you will either stay invested with the lump-sum you put in now or the time you have to invest via SIPs till you reach the goal.

So while I still have 22 years to retirement, I have only 5 years to buy a Car.

Do you think it is wise for me to risk money in five year time horizon? And how much risk is rational? Maybe I’m happy to look at 75% equity for a retirement allocation, but only 50% for a five year goal, and then no equity for an emergency fund.

As you will now better understand why looking at your investments in terms of goals make sense.

Each goal, depending on the time horizon, will have its own asset allocation. Your portfolio allocation is a weighted average of individual goal’s allocation.

Most of us approach it the other way round, isn’t it?

Someone suggested, “you are too young, you should have 80% in equity”. Because they think you are investing for the long term. While you are not even bothered with retirement, you want to buy a ferrari in next five years!

Is 80% in equity a rational choice? Well, that depends on the other factor – your risk tolerance.

Risk tolerance by definition is more tilted toward the psychology of an investor. Are you ready to risk it more for better potential returns? Or do you want to not lose a penny, even if it means not earning a penny as well?

When the risk tolerance is high, you may need to invest comparatively lesser towards a goal since the corresponding returns are potentially high. Meaning lesser money invested with better returns will take you to the same goal that needs more money invested with lesser returns.

So, by definition,  if you are an aggressive investor you will go ahead with 80% in equity to buy a car. You are risking a probability that after 5 years, you may end up losing some money and not be able to buy a car.  

Doesn’t sound quite convincing, isn’t it?

Why would you risk fulfilling your goal at all? Why would you invest for five years only to end up not buying your dream car?

The questions you have are rightly placed. Your risk tolerance is also derived from your existing financial situation and investments.

Say you have Rs 50 lakh to invest, while you have 50 lakh more in FD. Even if you invest entire 50 lakh in Equity, your portfolio allocation is equity and debt is still 50/50, which  may be a moderate risk exposure as per your life and financial situation.

There can be a situation where your risk aversion may be pulling you down and in practise, I have seen how a good advisor can help you build your risk appetite and exposure.

One way that appeals to a lot of Risk averse investors is to park their funds in debt and invest interest earnings into Equity. This ensures your capital is preserved while overtime your equity exposure increases.

So Equity & Debt is all we will talk about?

Yes and no.

Yes, because those are the asset classes we deal with at Capitalmind Wealth 🙂

No, because we want to mean more to you than a business.

So, the three major asset categories traditionally have been Stocks, Bonds and Cash. However, Gold, Real Estate, Commodities, Futures , Derivatives and Crypto have been added over the years by investment professionals to build a more realistic view of client’s portfolio.

We talk of Equity and Debt because that’s where you start from.

In practice people deal with gold and real estate at personal level, buying it when they feel the need or when they have enough parental pressure. That’s not really about it being a financial goal – just a long term financial investment. But that may not be a right approach.

My brother was on the brink of buying a flat when he sat down with a financial advisor. It turned out Real Estate, at that time, wasn’t a fit into his financial profile. 

Not to say that real estate is not a good asset class, but it may not make sense in your portfolio at this point in time and may be better planned later.

A good financial advisor will know. 

Asset Allocation ensures your money is best equipped to do what it needs to do. A right asset allocation is half the job well done.

The other half, you ask. We will write about that soon!