In investments, we all want to time the markets or select the “best” stock, mutual fund or any other investments. We find out later (the hard way) that they are not in our control mostly. But there’s something that’s in our control and that’s called asset allocation. Let’s understand this thing that’s called asset allocation.
Let’s imagine a journey from Mumbai to Delhi. There are various methods of going from Mumbai to Delhi. We can travel in a train, car or a plane. You can also hitchhike your way and reach Delhi after a long meandering journey. In a train, you can travel first class or in sleeper class.
Similarly, your investments also have various classes as options. These are called asset classes. There are different asset classes of investments. In common parlance, the various asset classes are debt, equity, gold and real estate.
Your investment journey can also be planned by using the various above options and the technical word for this plan is “asset allocation”.
The key factor to decide is the time in which you want to reach your destination. Your safety and comfort are the other two factors in deciding your asset allocation.
Let’s dig a bit deeper and understand what and how of asset allocation.
What is Asset Allocation
Asset allocation is based on the idea that in different years a different asset is the best performing one. It is difficult to predict which asset will perform best in a given year. Thus, although it is appealing to try to predict the “best” asset, proponents of asset allocation consider it risky. They say that someone who “jumps” from the one asset to another may easily end up with worse results than any consistent plan.
Studies have pointed out that replacing active choices with simple asset classes worked just as well as, if not even better than, professional fund managers. The study also pointed out that a small number of asset classes were sufficient for financial planning. This study supports the idea that asset allocation is more important than all other concerns like market timing, finding the right asset class every year, stock selection, etc.
Let’s begin with a few snapshot data. In 2000, the Sensex gave you a -26.1% return, Gold -3.33% while Debt Funds gave a +10.19% growth. But in 2006, it was +46.7 for Sensex, +5.28% for Debts and 35.0% for Gold. Every year, there’s a different growth story for the three asset classes.
And nobody knows for sure what 2020 will give returns on the three asset class. If the papers tell you that Debt funds are doing well and you take out your equity investments and put them into Debt, chances are that the equity is back to performing well and the debt funds nosedive.
If nobody knows when and what returns will an asset class give, jumping from one asset class to the other is really a bad idea, right?
How to set up your Asset Allocation?
Essentially Asset Allocation is your Investment policy. Depending on your own understanding of your risk profile, you need to finalize the best fitting pie for your debt, equity and other investments.
To start off, the thumb rule of asset allocation is based on your age. So if your age is X, invest X% in debt and 100-X% in equity. If you are a 25 year old guy, invest 25% in debt and 75% in equity. Always remember, it’s just the thumb rule.
What are the takeaways from this knowledge of asset allocation? Let’s take it in steps.
Step 1: Understand Yourself
There’s always a risk-return trade off. You must know whether you can absorb the shocks of short term losses when you aim at higher returns. It’s not possible that you want attractive returns and you are not exposed to a few shocks here and there. So be aware of your risk profile to start with. The three broad categories of risk profile are: Aggressive, Moderate and Conservative. Which one is your risk profile?
Step 2: Understand the Asset Classes
We must invest in assets we understand. Blindly investing in any of them could be disastrous especially equity. So one should know what options are available under equity and debt assets and then take a reality check on our comfort level with them.
Step 3: Decide your allocation ratio
Now you knew the thumb rule that if you are a 25 year old guy, invest 25% in debt and 75% in equity. But after going through steps 1 & 2, it’s time you set a allocation ratio for yourself. You should allocate according to your risk appetite and not because of some thumb rule. Moreover, you can also allocate funds for equity classes like gold and real estate too.
Step 4: Balance the Portfolio
We need to monitor the portfolio and rebalance it to the original allocation ratio. Why? Well, once you have invested (for example) Rs 1,00,000 , Rs 50,000 in equity and Rs 50,000 in debt funds the portfolio will change it’s ratio over time. In a few months, the equity portfolio may be valued at Rs 75,000 and debt portfolio at Rs 55,000 , total Rs 1,30,000. (just an example). So if you want to maintain your asset allocation ratio of 50% each, you may have to sell Rs10000 from your equity and invest the same in debt to make them valued at Rs 65,000 each.
By maintaining this asset allocation ratio, you are booking profits when the equity markets rise. Similarly, you are buying more equity when the stocks go down, thereby reducing your cost of your stocks acquisition. This is what asset allocation can do for your financial health.
“Since a common investor can’t really time the market successfully or select the right stocks, asset allocation should be the focus of his/her investment strategy. This asset allocation is the only thing that the common investor can control.”
Call it asset allocation or modern portfolio theory (they even got a Nobel Prize for the theory in 1990!), in essence it is about not putting all your eggs in one basket. A wise and common sense approach to investing is to create a portfolio across various kinds of investments across different asset classes.
Asset allocation is your plan for investing, a plan to organize your portfolio among debt, equity and other asset classes. It’s a diversification plan.
Asset allocation is the only element in your portfolio that you can control. So to conclude, the asset allocation or the investment plan is more important for you than the investments themselves.
Do you have questions or thoughts on asset allocation. Please share with us in the comments below.