First
lesson of investing: Asset allocation
Several
people think that asset allocation is simply a theory. Nothing can be further
from truth. When the money is spread across various types of assets, we control
our investments better and the overall risk is reduced.
The past five years have demonstrated the power of allocation to most investors. In 2008, equity crashed while commodities boomed; in 2009, debt crashed as equity returned; in 2010, equity boomed again, even as commodities corrected; in 2011, gold appreciated while equity crashed; and in 2012, debt is doing well even as equity is languishing. Ask a lay investor the steps he should take to protect against these violent swings in return, and the answer is likely to be either of the two-book profits early or master the market timing. Both the views are incorrect. Different assets do well at different points in an economic cycle, and it is risky to time the market. An investor who has exposed himself to various assets will do immensely better.
How should one allocate money to various assets? Assets work in two waysthey either generate regular income or grow in value over time. A bank deposit does not grow in value, generating only regular, periodical income. Investment in gold does not generate any income, only potential growth in value over time. Equity shares primarily generate growth, but can also provide income by way of dividends. Property may offer both types of returns-from rent and capital appreciation-though rental yields may be too low in the initial years of investment. Thus, asset allocation begins by asking what you need and, therefore, what your allocation should be.
It is important to align the allocation with the purpose for which the money is needed. Income assets are suitable for short-term, low-risk needs that require a regular cash flow. Income assets are also suitable for situations where the capital cannot be subjected to risk. Growth assets, by definition, will grow in value over the years, but it will not be a straight, risk-free line. The value of growth assets may fluctuate in the short term, while the appreciation in value may be significant over the long term. Hence, these are suitable for long-term goals.
It is obvious that asset allocation not only varies with needs, but may also change with time. An investor saving for the higher education of his child needs growth when the investment is accumulated, and income when the child enters college. An investor saving for retirement needs growth assets when he is putting money aside, and income assets when he retires and needs regular income. The most common errors in asset allocation occur when it is seen as static. Several investors, who think that a precious goal like a child’s higher education should not be subject to the risk of growth assets, end up saving a higher amount than needed, sacrificing their other financial goals.
The simplest rule is to ask when the income will be needed. For a salaried person, whose need for income is met by deploying the human asset, the need is for growth assets like equity, property and gold. A retired investor, whose requirement for income is to be met by the investment corpus, needs assets that generate regular income. The dominant asset should be determined by the investor’s need for growth or income. This is called the core portfolio, which is aligned with the strategic needs of the investor. A retired investor, who seeks an income over 30 years into retirement, will need his corpus to grow over time, so some money should be in growth assets. The smaller allocation is the satellite portion, which needs a close review. About 60% to the core portion and 40% in satellite is a good rule to work with. Such an approach does not need a market view and should do fine across market cycles.
What are the common errors? First, investors like to measure their investment according to the income and dividend they get. Choosing a reinvest option, growth or cumulative option, helps. Some products like the PPF earn interest on reinvested interest and are good choices for customers who like a steadily growing asset. Second, investors mistake the compounded growth rate of a
growth asset to be its steady rate of return. If an adviser tells you that equity gives a 15-16% return, this is an average over a number of years. Third, asset allocation requires review and planned rebalancing. An investor, who is saving in growth assets for retirement, should not hope to switch from growth to income in an instant on retirement. The process needs to be done gradually over time.
What are the benefits of asset allocation? First, investments are aligned with investor needs and enjoy the benefit of attention. They do not sway with fads and fancies. Second, since different assets do well at different points in time, the portfolio is diversified and faces lower risk. Third, participation in various assets ensures a stable rate of return aligned with the investor’s needs. This may result in an optimal level of saving. The wrong choice of assets often leads to overfunding of goals like retirement.
— An exposure to various types of assets gives better returns since the risk is lesser
The past five years have demonstrated the power of allocation to most investors. In 2008, equity crashed while commodities boomed; in 2009, debt crashed as equity returned; in 2010, equity boomed again, even as commodities corrected; in 2011, gold appreciated while equity crashed; and in 2012, debt is doing well even as equity is languishing. Ask a lay investor the steps he should take to protect against these violent swings in return, and the answer is likely to be either of the two-book profits early or master the market timing. Both the views are incorrect. Different assets do well at different points in an economic cycle, and it is risky to time the market. An investor who has exposed himself to various assets will do immensely better.
How should one allocate money to various assets? Assets work in two waysthey either generate regular income or grow in value over time. A bank deposit does not grow in value, generating only regular, periodical income. Investment in gold does not generate any income, only potential growth in value over time. Equity shares primarily generate growth, but can also provide income by way of dividends. Property may offer both types of returns-from rent and capital appreciation-though rental yields may be too low in the initial years of investment. Thus, asset allocation begins by asking what you need and, therefore, what your allocation should be.
It is important to align the allocation with the purpose for which the money is needed. Income assets are suitable for short-term, low-risk needs that require a regular cash flow. Income assets are also suitable for situations where the capital cannot be subjected to risk. Growth assets, by definition, will grow in value over the years, but it will not be a straight, risk-free line. The value of growth assets may fluctuate in the short term, while the appreciation in value may be significant over the long term. Hence, these are suitable for long-term goals.
It is obvious that asset allocation not only varies with needs, but may also change with time. An investor saving for the higher education of his child needs growth when the investment is accumulated, and income when the child enters college. An investor saving for retirement needs growth assets when he is putting money aside, and income assets when he retires and needs regular income. The most common errors in asset allocation occur when it is seen as static. Several investors, who think that a precious goal like a child’s higher education should not be subject to the risk of growth assets, end up saving a higher amount than needed, sacrificing their other financial goals.
The simplest rule is to ask when the income will be needed. For a salaried person, whose need for income is met by deploying the human asset, the need is for growth assets like equity, property and gold. A retired investor, whose requirement for income is to be met by the investment corpus, needs assets that generate regular income. The dominant asset should be determined by the investor’s need for growth or income. This is called the core portfolio, which is aligned with the strategic needs of the investor. A retired investor, who seeks an income over 30 years into retirement, will need his corpus to grow over time, so some money should be in growth assets. The smaller allocation is the satellite portion, which needs a close review. About 60% to the core portion and 40% in satellite is a good rule to work with. Such an approach does not need a market view and should do fine across market cycles.
What are the common errors? First, investors like to measure their investment according to the income and dividend they get. Choosing a reinvest option, growth or cumulative option, helps. Some products like the PPF earn interest on reinvested interest and are good choices for customers who like a steadily growing asset. Second, investors mistake the compounded growth rate of a
growth asset to be its steady rate of return. If an adviser tells you that equity gives a 15-16% return, this is an average over a number of years. Third, asset allocation requires review and planned rebalancing. An investor, who is saving in growth assets for retirement, should not hope to switch from growth to income in an instant on retirement. The process needs to be done gradually over time.
What are the benefits of asset allocation? First, investments are aligned with investor needs and enjoy the benefit of attention. They do not sway with fads and fancies. Second, since different assets do well at different points in time, the portfolio is diversified and faces lower risk. Third, participation in various assets ensures a stable rate of return aligned with the investor’s needs. This may result in an optimal level of saving. The wrong choice of assets often leads to overfunding of goals like retirement.
— An exposure to various types of assets gives better returns since the risk is lesser
Uma
Shashikant The author is Managing Director, Centre for Investment
Education and
Learning TOI120730
Learning TOI120730
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