Money is the fuel all we need to pursue our life’s goals. Investing judiciously is one way to grow our hard-earned money at a healthy rate over time. Of course, one has to follow the right investment process to do so. Unfortunately, many investors start investing without determining their goals and the right asset allocation.
What they fail to realise is that while the portfolio’s performance is important, its allocation or diversification over time is more significant.
Asset allocation is a strategy which allows an investor to choose from various asset classes such as equities, debt, real estate and commodities. Here’s a look at what one needs to consider while weighing options.
Time horizon: It is the expected number of years one would be investing for. An investor with a longer time horizon would generally have the capacity to invest in riskier or more volatile asset classes as he can wait out the inevitable market ups and downs.
Risk tolerance: It is an investor’s ability and willingness to take risks to achieve the desired results. An investor with high risk tolerance is more likely to risk losing money for better results. When it comes to identifying risks, most investors focus mainly on the market risk. There are a variety of risks:
Market risk: This is common to an entire class of assets. Consequently, the portfolio value may decline on account of economic changes or other events that impact the market place. Diversification and rebalancing the portfolio periodically helps manage risk.
Inflation risk: This involves the risk of losses resulting from erosion in income or the value of assets due to the rising costs of goods and services. It is a major risk in debt and debt-related securities.
Longevity risk: An investor might outlive his assets. Hence, it is necessary to design a portfolio having the potential to provide a positive real rate of return.
Behavioural risk: Many investors follow haphazard strategies when faced with uncertainties. This often causes substantial impact on their investment results.
Sequence risk: Even as having a financial plan and following it in a disciplined manner helps, one can still experience a market downturn just around the completion of one’s time horizon. Therefore, it pays to start protecting gains by altering asset allocation of the long-term goals in a phased manner, say around 12-18 months, before the target date.
While asset allocation is the key to investment success in the long run, it is equally important to choose the right options to get the desired results. Several factors such as variety, flexibility, liquidity, tax efficiency and transparency need to be considered in the selection process. It is here that an investment option like a mutual fund scores over most others.
The author is CEO, Wiseinvest Advisors
