If you want to protect your money from the vagaries of uncertain markets, you must learn about asset allocation
Let’s say you had invested all your money in equities in 2000 and remained invested till 2007. Your money would have grown four-fold by the end of 2007 and you would have reaped bumper gains. If you had invested all your money in fixed deposits or debts, your money would have less than doubled in seven years.
Now imagine that you invested all your money in the second half of 2007 in equities. Your money would have given almost zero return still 2015. Had you invested all the money in fixed deposits or debts, you would have again less than doubled.
While the first scenario is profitable, the second is loss making purely from the equity point of view. This is why investing in multiple assets is important. Investing in multiple assets is known as asset allocation, which is the key to managing risk and building wealth.
Investment choices for investors
As explained earlier, asset allocation is important so that any adverse market condition in one asset class doesn’t impact your total investment adversely. At a high level, investing offers two types of assets. The first is where the returns are not fixed, while the second type is where the returns are fixed.
The first category consists of equities, gold, land, while the second category consists of bonds, fixed deposits, government securities, post office deposits, etc. In this article, we will mainly focus on equity in first type and any of the fixed income securities in the second type.
Asset allocation: a function of risk and investment horizon
Asset allocation depends on your investment horizon as well as your risk appetite. Let’s look at each separately.
Risk appetite: Risk in investment simply means the uncertainty of returns. Equities come under highly risky investment category because the returns are uncertain. In some years, equities can give as much as 50 per cent returns, while in some years the losses can be equally staggering. This is what makes equities risky. In contrast, government bonds, high grade corporate bonds, and fixed deposit schemes can give 7-9 per cent every year depending upon prevailing interest rate. Hence these are called less risky investments but offer low yields.
Investors who have high risk appetite invest a larger part in equities and a smaller part in bonds, while investors with low appetite for risk do the reverse.
Investment horizon
Asset allocation also depends on the investment horizon of the investor. Equities or high risk investments are subject to market fluctuations and hence tend to move either ways in short term. Hence investors with short term target should not go for equities.
Suppose an investor has Rs 10 lakh now and wants to buy a home in the next three years. He wants to put this money into an investment. This means his investment horizon is three years and he will need this money after three years when he goes to shop for a home. While he might be tempted to put all in equities hoping to double the money in next three years, this may backfire. His best strategy would be to put the money in fixed deposits, bonds or bond funds. If at all his risk appetite is high, he may go for balanced funds which invest partly in equities and partly in bonds.
However, if an investor is building wealth for his reti-rement, he can go for investing major part in equities.
Investment horizon is directly linked with the current age of investors. An investor in his 20s or 30s has more years to invest and hence can take risk by investing major part in equities, while an investor in his 40s and 50s cannot invest the same proportion in equities.
A thumb of rule is to subtract your age from 100 and invest that percentage in equities and rest in debt. If you are above 60, do not go for equities unless you have more money than you need for the rest of your life.
How to invest in different assets under asset allocation
Now that you have fair idea about asset allocation, let’s see how you can implement the asset allocation strategies in your case.
Investing in equities can be done in two ways; either by investing directly in stocks or by investing in equity mutual funds. Investing directly in stocks is not advisable unless you can study companies’ financials and understand few economic terms and their impact.
Investing through mutual funds is the best way for common investors to invest in equity market. Mutual funds invest in a set of companies and run by expert fund managers. You can start an SIP (Systematic Investment Plan) to invest in mutual funds.
Investing in fixed income:
Fixed income products include bank deposit, corporate bonds, government securities and schemes such as annuities, and infrastructure bond funds. All these investments are risk-free or of very low risk. The-re are also mutual funds known as balanced funds and bond funds. Balanced funds invest in equities and bonds while bond funds invest in bonds only.
Key Points for investors
In many cases, investors tend to ignore the importance of asset allocation and investment horizon and are prone to knee-jerk reaction by investing their entire amount in equities during an irrational bull market or all in bonds in an overly pessimistic bear market. Follow your risk appetite and investment horizon strictly to form a portfolio and build wealth over time. At the same time, as your investment grows and your investment horizon changes, you should revisit your portfolio and change the composition of equity and debt if required.
As far as investing in equities are concerned, do not invest unless your investment horizon is at least five years. Equities fluctuate widely in the short-term while they tend to give good returns in longer term. Take decisions based on your investment horizon, knowledge, and risk appetite.
Finally, despite the rules, asset allocation is a subjective concept. What is risky for one may not be risky for others. For example, a person who has fair idea about stock market will invest in equities even at the age of 50. Similarly, a person with low risk may invest a major part in bonds irrespective of his or her age.
Source - asianage.com
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