7 Factors to consider for Asset Allocation
While all of us aspire to create wealth for ourselves and for the comfort of our families, in today's time of rising cost of living, it is imperative to understand a host of factors before one binges into a risky asset class such as equities to achieve one's life goals. Although, equities appear the best investment option to make the most of in a stock market rally, it is not very wise to nest all eggs in one basket. This is sometimes comprehended by people only in conditions of adversity (such as a sharp decline in stock market), when investors have parked a large portion of their corpus in a particular asset class (in this case, equities).
It is vital for you to understand that not all assets move in the same direction at the same time. If equities are witnessing a bear market, it is unlikely that other asset classes such as gold, debt instruments, real estate will also be witnessing a down-turn at the same time or vice-versa. Hence it is best to invest in more than one type of instrument to improve your chances of achieving your long-term goals with minimal turbulence. You see, planned asset allocation acts as a shield to protect your wealth during uncertain economic conditions and market volatility.
So how can one really allocate his / hard money wisely?
Well, here are some factors which one must take while you intend to allocate your assets - hard earned money wisely, as they provide a comprehensive picture.
You see, diversification of assets gives you a lee way to counter market uncertainties and acts as a stabiliser for your portfolio when a particular asset class crashes. Broadly an effective asset allocation offers the following 4 benefits which are:
Your age is an important factor that you must consider while deciding your asset allocation. If you are a young investor of say 20-30 years, you should consider allocating a large percentage of your portfolio in risky assets, such as equities. Being young gives you ample amount of time and opportunities to recover from any possible setbacks in the value of the portfolio. If you belong to the middle age group (30-55 years), you must aim to create a moderately risky portfolio and should not invest your entire savings in equities. On the other hand, aged investors, nearing their retirements (55 years & above), should follow a highly conservative approach when planning their asset allocation and prefer debt or fixed income instruments so as to preserve the principal amount.
You see, the amount you invest is a function of the amount of income you earn. Any appraisal in earnings, will impact your discretionary income and hence the amount of investment. If you are into service or employment, drawing a fixed salary every month, you can allocate your savings systematically to both risk and safe instruments depending on your age. However if you are in the business industry, your profits and losses are not fixed in nature. While higher profits will lead you to expand your business or invest in various financial instruments, a year of losses will have a direct bearing on your ability and capability to invest. Hence, it is imperative for you to allocate your assets keeping in mind your future income growth potential.
In order to keep your financial health in pink in the long-term, it is important that you live within means and curtail your unnecessary expenses. It is this strategy which will enable you save a large portion of your monthly earnings, which can be deployed in suitable asset classes (depending upon your age, income, risk appetite and nearness to goal). We recognise that while certain expenses such as loan repayments, rent, grocery bills etc. cannot be avoided; you can always stream line few of your unnecessary and extravagant expenses. This will enable you to increase the net free cash available for asset allocation, which in turn if invested wisely can enable you to create more 'wealth' and fulfil your financial goals.
- Nearness to goal:
Your nearness to your financial goal is also relevant while doing financial planning. If you are many years away from the financial goal, you should ideally allocate maximum allocation to the equity asset class and less towards fixed income instruments. So, say you have a financial goal of getting your daughter married well after 20 years from now; it would be prudent to invest in equities (either through the direct route or through equity mutual funds). It is noteworthy that the concept of allocating funds to different asset classes based on your nearness to goals helps not only to diversify risks across different asset classes but also in rebalancing your portfolio when you are closer (in terms of number of years) to the achievement of your financial goals. You see, when you are drawing nearer (3 years) to your financial goal(s), you must shift your corpus to fixed income instruments to safeguard and avoid risk asset classes to preclude wealth erosion.
- Risk Appetite:
Your willingness to take risk which is a function of your age, income, expenses, nearness to goal, will be an important determinant while framing your financial plan. So, if your willingness to take risk is high (aggressive), you can skew your portfolio more towards the equity asset class. Similarly, if your willingness to take risk is relatively low (conservative), your portfolio can be skewed towards fixed income instruments, and if you are a moderate risk taker you can take a mix of equity and debt respectively.
If you as an investor have high liabilities, then even though you may be willing to take high amount of risk, your financial condition would make you a risk-averse investor. Irrespective of age, willingness to invest, nearness to his goals, risk tolerance or any other factor, you will be forced to only make safe investments as you cannot afford to let your investments suffer any setbacks due to market swings. Also, you must avoid taking loans or increasing liabilities to generate funds to invest in risk assets such as equities as any losses endured here might worsen your financials.
As an investor, it is imperative to first analyse your existing portfolio before allocating funds further. For instance, if a huge chunk of your portfolio is dominated by real estate, then you must diversify your assets in a manner that reduces your allocation to risk assets such as real estate or equities and increase investments in safe instruments such as debt and cash. And while you do that be cognisant of the aforementioned facets which we discussed.
Ideal asset allocation:
- Lowers investment risk
- Reduces dependency on single asset class
- Protects during turbulent times
- Makes timing the markets irrelevant
Under ideal circumstances, Investors whose objective is to achieve long term capital appreciation and have an aggressive risk appetite can invest upto 70% in risk assets such as equities and related instruments, and the remaining 30% in safer asset classes such as debt and cash instruments. Moderate Investors, who aim at providing some stability to their portfolio along with capital growth, must invest upto 60% in equities and balance (40%) in debt and cash. Conservative Investors', who prioritize the protection of their capital must upto 70% in debt and cash, while the rest can be diversified by investing in quality equity instruments. However, before you follow this ideal asset allocation, be cognisant about the aforementioned facets which we discussed.
PersonalFN is of the view that asset allocation safeguards the overall value of your portfolio from the misfortune of any particular asset class. It is not a one-time process and you must keep reviewing your asset allocation from time to time to ensure it is in line to achieve your financial goals.
PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.
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