Asset Allocation

What exactly is asset allocation and why is it important?

In simple terms, it is a strategy to balance risk and reward of your investments. It is like selecting your cricket team. In a game of cricket, would you selected 3 batsmen and 5 bowlers? Or would you refer more all-rounders? Asset allocation is all about structuring your various investments in a way that fits into your investment objective. How much risk are you willing to take?  And what returns are you trying to achieve?

The most important part of an asset allocation strategy is risk management. It is important that you secure yourself from risk as a starting point. Risk can be different types. A significant risk is about losing your capital. But a very important and often unseen risk is that of inflation. If your asset is not beating inflation that your assets will continue to be worth less every year.

 First of all, what are the key considerations when you design your portfolio? Every asset class is different with its own unique features. While working on your asset allocation, the first thing to consider is the risk and return ratio. How risky is the asset? And what are the expected returns? While most people tend to see risk and return easily, often we lose sight of things like liquidity? How quickly can you convert the asset into cash in case you need to? As an example, an investment in shares or mutual funds can be easily converted into cash within 3 – 4 days. Whereas an asset like land may take a few months or years to convert into cash.

 Another consideration is the active management required to manage the asset. As an example, if you own a flat which you rent out, there is a certain amount of active management required. This may include repairs, periodic signing of leave and license agreement etc.

One other thing is physical management of an asset like gold. I am personally not a big fan of physical gold. Because it comes with a lot of hassles to handle it and keep it safe.

Let’s begin by looking at various asset classes. 

Fixed Deposits: The most popular one is India is fixed deposits with a bank.  These types of assets are usually relatively low risk but also give a relatively low return. Note that I mentioned relatively low risk. Remember that there is no asset class that is completely risk free. Some may have high risk and others low risk.  Fixed deposits are very popular in India due to several reasons. First of all, most people seem to understand the asset class. Another important reason is that a fixed deposit can be purchased at the local bank. Most likely the branch manager will approach you to start a bank deposit. And the most important reason is the fixed return. This I think is the most appealing reason for a fixed deposit being the asset of choice. However it is not the first option for me. Fixed deposits have merits. Limited merits. On the positive side, FDs are easy to understand and provide a fixed rate of return. Unfortunately the return is low and often same as or slightly above inflation. This issue coupled with the tax impact make a FD my least favorite asset class. Remember that FDs are taxed at the same rate ads your regular income. 

Property: Historically property have been a popular asset class. Property can be further divided into 2 categories; land or plots of land or rental property. In a highly accelerating rate of urbanization, property has proven to be a good asset class in the past. Specially rental property given the relatively fair appreciation in value in the past and also the benefit of periodic cash flow in the form of rent. On the flip side, property required active management. Often land suffers from issue of encroachment and several other complexities. In the case of rental properties, a lot of active work is required in the form of maintenance, documentation and the sometimes a cranky tenant.  Finally remember that property is not a liquid asset class. It is not easy to convert the property into cash at short notice. It is a rather a long and complex process to liquidate a property.

Gold:  Gold has been and is a very popular asset class. Families have past on gold through the generations with each generation adding to the kitty. Most often the investment is in physical gold in the form of ornaments although some may include gold bullion. And while gold remains a popular investment option, this is definitely not among my favourites. Specially given my experience with gold!  In the past I have held gold bullion but I found it is a hassle to manage aside from relatively lower returns. Given my several moves across cities in the past, moving the gold was one of my biggest headaches. Gold requires a lot of physical management. Moreover, it is not easy to liquidate contrary to popular opinion. 

Equity: Equity is by far my favourite asset class.  I am a huge fan of this asset class given its past performance and several other features discussed below. First of all equity is known to beat inflation over the long term and this is the most important reason for my soft spot for this asset class. Remember than inflation can slowly eat into the value of your assets and hence it is extremely important that the return beats inflation. Often people refer to investments in equity as gambling. This is why I say this asset class is vert misunderstood. I think the relative volatility of investments in equity give people the impression of a casino. However it can be proven and back tested that investments in equity are far more rewarding that most other asset classes. Investments in equity can be further classified into 2 broad categories:

Direct equity: One route to investing in equity is to invest in shares of companies. In this process you buy shares of certain companies and become a part owner of these companies. This however comes with the risk of not knowing which companies to invest in. Sometimes companies that you invest in may suffer from poor performance and lose value. Hence this is an area that is best left to the experts although one may allocate a small portion and learn the intricacies along the way.

Mutual Funds: Another route to investing in equity is via mutual funds. A mutual fund is a common pool where multiple investors pool their money and an 'expert' fund manager invests in the various companies on your behalf. This partly takes away the risk of investing in bad companies since the choice of the companies is left to the fund manager (a fund manager may also make poor decisions). 

So what is the best asset allocation? There is none.

Each investor is unique and has unique circumstances. Hence every individual investor is different and have different needs. It is important that you review your own circumstances and needs and design something that works for you.  There are several thumb rules for this.

An important approach is age based. At a young age, allocate more to equity and less to fixed deposits or debt funds. This is one account of the long road ahead for active income which provides enough time for you to ride out the volatility while the magic of compounding kicks in.  As one moves to middle age or closer to retirement, it would be prudent to lower the exposure to equity and hence lower exposure to volatility.   Read my detailed post about this methodology here.

Would you like to have a chat about your asset allocation strategy? Email me at firstlifeskillz@gmail.com  Remember I am just an amateur and I don't sell anything. I am not remotely affiliated to any company that sells financial products.