The objective of balancing risk by diversifying is seldom achieved by investors. Most tend to go overboard on any one, depending on the circumstances. Consequently, the process of investing, for most investors generally, means deliberating over which particular instrument to invest in.
Most investors don’t really put all their eggs in one basket. In all probability you would have invested some money in direct equity, some in mutual funds….there would be a PPF account or two. Gold and bank deposits would probably round off your diversified portfolio. However, notice that I have referred to ‘consciously spreading your investments’. Do you know exactly what proportion of your investments are contained in which asset(s) and why? Though we all do eventually park our money in diverse instruments, the resultant asset allocation is more of an accident than design. For example, we tend to succumb to current market sentiment and the flavours of the season.
Asset allocation is paid little attention to. In spite of the fact that the starting point of any investment plan is a properly devised asset allocation strategy. Basically, asset allocation refers to the process of consciously spreading your investments across various asset classes in order to insulate your entire portfolio from the poor performance of any one single class of securities.
Some time back, it was equity. Then came the downturn and investors turned their attention to FMPs, bank and corporate fixed deposits. Now, that the market is rallying on the back of the reforms announcement, once again, there will be a clamour for equity. This throws the portfolio off kilter, thereby sub-optimising the total return.
Now, if a tailor-made, suitable asset allocation strategy were in place, it would have first indicated that rather than going overboard on fixed deposits during the market downturn, you should actually be adding a little to your equity portfolio. Basically, sticking to your allocation pattern would discipline you to buy low.
And now eventually, when the market has picked up, sticking to the allocation pattern would have you actually reducing the equity component in your portfolio. In effect, you would have booked profits, thereby pocketing some gains and at the same time continued participation in the market — all with no additional risk than what you originally started out with. So regardless of the external environment, maintaining a strict asset allocation policy lets you maintain a risk level that you are comfortable with.
Therefore, while investing is important, asset allocation is critical. In other words your selection of specific stocks, bonds or deposits is actually secondary to the decision of how much to allocate between the high and low-risk investments.
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Determine Your Goals
That being said, we come to another aspect of the planning process and that is setting achievable goals. Without having carefully thought out financial goals, any asset allocation or investment plan will be meaningless. It will be like starting on a journey without any particular destination in mind. Note however that the goals have to be realistic and objective.
For example, you may wish to start a small business after retirement, your daughter wonders if you could lend a little financial support for her education abroad, you also want something in hand for her marriage when the time comes and then there is this small row house that you always wanted to buy at your native place…..yes the wants are many and all may or may not be fulfiled. However, the thing to do is to put it down on paper, in terms of cold numbers. This way, you have graduated from having a hazy idea about your requirement to being fully seized with at least a broad ball park figure.
Now, in the case of your post-retirement needs, you need not worry about short-term fluctuations in the stock market. A large part of your investment for this purpose should go into stocks and mutual funds. But if your daughter is say four years from entering college or getting married, you may need to tilt your asset allocation to safer fixed-income investments.
Rebalancing
Last but not the least there is rebalancing. As you must have figured out by now, by definition, asset allocation can never a one time exercise. Therefore, it is important to conduct periodic portfolio reviews, since over time the value of the various assets within your portfolio will change thereby affecting the weight of each asset class.
So in order to reset your portfolio back to its original state you need to rebalance your portfolio. Therefore, you would need to sell portions of your assets that have increased significantly and channel those funds to purchase additional assets that have fallen in value or increased at a lesser rate.
To sum up
As Shauna Carther of Investopedia so succinctly puts it, the eventual goal of any investor is to maximise return for a chosen level of risk or stated another way to minimise risk given a certain expected level of return. The only way to achieve this goal on a consistent basis is by conscious asset allocation. Or as they say, failing to plan is planning to fail.
The writer is Director, Wonderland Consultants