Investing is a combination of art and science. If it was pure science, then there would have been a formula that would create millionaires every day.
Or, people with high IQs would outperform the others. It is not gambling either, that is based on pure luck.
Successful investing is about having a strategic investment plan and spending time in the markets to develop an understanding of them.
This eventually evolves into an aptitude for picking the right investments and making perfect sell decisions.
However, to be a successful investor, you need to go through a journey of discovering your preferences and creating an investment plan that suits you, and helps achieve your financial goals.
While there is no formula, there are techniques that can help you create an investment portfolio that works as hard as you do, to achieve your goals.
Today, we are going to talk about one such technique – asset allocation and share everything that you need to know to understand it comprehensively.
In this article
- Investment Plan – The Hallmark of a Successful Investor
- Asset Classes – Basic understanding and types
- Understanding Asset Allocation
- A Step-by-Step Guide to Asset Allocation
- Asset Allocation & Portfolio Diversification
- Summing Up
Investment Plan – The Hallmark of a Successful Investor
As an investor, there are three aspects that need your attention:
- Financial goals – these will help determine the required rate of returns to achieve your target in a given period. For example, if you have a financial goal of buying a house within the next five years and want to create a corpus for it, then based on your investment amount, you can calculate the expected rate of returns that you need to get there.
- Risk Tolerance – this needs to be understood carefully as different instruments have different risk exposures and buying the one matching your tolerance levels is important. If you have a lower tolerance and purchase a high-risk investment, then you might not be able to handle the volatility and make rash decisions. On the other hand, if you have a higher tolerance, then the investment might not perform up to your expectations.
- Investment Horizon – If your financial goal is to buy a house within five years, then you need investments that will cover the requirement rate of return with minimal risks within the period. If an instrument requires a 7-10-year investment window, then it will be of no use to you. Therefore, it is important to understand the investment horizon that you are comfortable with and choose investments accordingly.
These three aspects are the pillars of your investment plan. Based on your preferences across these points, the next step is to choose assets to invest in. The reason why we said assets and not investment instruments is because asset classes have certain associated risks and potential returns.
Asset Classes – Basic understanding and types
An asset class is a collection of securities that have similar financial traits like risk, liquidity, response to market volatility, tax treatment, returns, and ideal investment tenure.
The concept of investing based on an asset class was popularized by mutual funds since they targeted investors with specific risk tolerances and needed to inform them about the range of securities they would potentially invest in.
For example, an equity mutual fund usually targets investors with medium-to-high risk tolerance and invests in stocks or equity-related instruments like preferred stocks, warrants, options, etc. Therefore, investors with similar risk tolerances would have an idea about the securities that the fund manager would invest in.
Here are some popular asset classes in India:
- Fixed-Income – These include government securities, corporate bonds, corporate debt securities, money market instruments, etc. All securities that offer a fixed rate of return until maturity are covered under this asset class.
- Equity – These include stocks and equity-related instruments. These securities offer returns based on their market performance which in turn is influenced by various social, economic, political, and other macroeconomic factors.
- Gold – This asset class acts as a portfolio diversifier. With the risk-reducing, return-enhancing characteristics, Gold will continue to be a stable form of money with potential to store value in the midst of uncertainty for its holders for the foreseeable future.
- Cash and Cash Equivalents – These include treasury bills, money market instruments, commercial papers, and any other securities that have maturity up to one year and are highly liquid.
Understanding Asset Allocation
Now that we understand asset classes, let’s look at how it stitches back into a strategic investment plan. Usually, investors have multiple financial goals. So, you can have a goal of buying a house in five years, you cannot ignore your child’s higher education costs due in 10 years or creating a corpus for your retirement years.
Hence, you will have different investment horizons for each of these goals and varying risk tolerances too. While you might want to take added risks to generate wealth for buying the house, you might want to stick to low-risk investments for meeting the goal of your child’s higher education.
Hence, you need to choose asset classes based on your financial goals and risks that you are willing to take. This means that you may have to allocate your money in different asset classes to achieve your various financial goals.
Going back to our example of you planning to buy a house in five years and assuming that you are willing to take high risks with your investment, you can consider opting for equity as an asset class that offers higher potential returns but carries higher risks too.
On the other hand, for your child’s higher education, you can opt for a medium-risk alternative like a balance of equity and fixed-income investments to create a portfolio that has tolerable risks with reasonably high returns.
Asset allocation will depend upon the three parameters discussed initially – financial goals (returns expectations), risk tolerance, and investment horizon.
A Step-by-Step Guide to Asset Allocation
While I have explained the concept, here is a step-by-step guide to ensure that you allocate assets optimally:
Step 01: Assess your Risk Tolerance level
As explained above, your tolerance to investment risks can help you determine the asset classes that suit you. Risks mean the possibility of losing a part of your invested capital due to an underperforming investment.
Remember, that returns are directly proportional to risks. Hence, higher risks would mean higher potential returns and vice-versa. Each asset class has a risk-level associated with it. By assessing your risk tolerance level, you can choose asset classes that are best suited to you.
Step 02: Identify your Investment Goals and Time Horizon
This will also help to determine the asset classes that are ideal for you. If you have short-term goals with a low tolerance to risks and are comfortable with medium-to-low returns, then Cash or Cash Equivalents can be considered. On the other hand, if you have a long-term horizon with a high tolerance to risks and desire high returns, then equity as an asset class becomes a better option.
Step 03: Choose a mix of asset classes to suit your requirements
Let’s say that you have a medium-to-high risk tolerance, an investment horizon of around 10 years, and the expectation of a double-digit return. While this sounds like the profile of an investor who should opt for Equity as an asset class, it does not mean that he should not consider other asset classes. Keeping your investment plan in mind, create a portfolio that has a mix of asset classes working together to minimize risks and maximize returns. Hence, you can look at Real Estate or even Fixed-Income securities and create a diversified portfolio. Diversification is all about investing in assets that have a low correlation to each other. Therefore, when one drops in value, the other is not impacted in any way.
Step 04: Always keep the broader financial picture in view
Most investors make some tax-saving investments, an insurance policy, and have bank fixed deposits before they start looking at investing for achieving other financial goals. Hence, while creating an investment plan and allocating assets keep all these investments in mind and don’t allow your investments to skew in any one direction. A balanced approach to investments is the best one.
Step 05: Review and Rebalance Regularly
Life is dynamic. Hence, financial goals and risk tolerance levels can change with time. Therefore, it is important to review your investments regularly and rebalance them based on any changes in preference that you might experience.
Regardless of your risk tolerance level, sticking to a single asset class increases the overall investment risk. Let’s say that you decide to invest in the Fixed-Income asset class that has low risk and low potential returns. Since you are trying to protect your capital, this makes sense. However, last year we saw the RBI slashing interest rates to manage inflation and liquidity in the economy. This resulted in a drop in interest rates across securities offering fixed returns. Hence, if you were invested only in the Fixed Income asset class, then despite being a low-risk investment, your overall returns would have been impacted. However, if you would have invested in a mix of asset classes, then the risk might have increased a little but you could have earned better returns.
While on the topic of asset allocation, it is important to talk about portfolio diversification too.
Asset Allocation & Portfolio Diversification
Asset Allocation is about ensuring that the asset classes you invest in are in sync with your risk tolerance, investment horizon, and returns expectations. On the other hand, Portfolio Diversification is about minimizing the risks and maximizing returns of your investment portfolio without considering the investor’s profile.
Hence, portfolio diversification is a scientific process where the investor chooses asset classes that are not correlated with each other and tries to optimize returns while minimizing risks. On the other hand, Asset Allocation is an art where you understand your preferences and create a mix of asset classes best suited to you.
To summarize the entire concept in the simplest terms, before you start investing, understand (i) How much risk are you willing to take with your money?; (ii) The returns that you expect; and (iii) When do you need your investments to provide returns? The answer to these three simple questions will reveal your profile and help you choose investments in a more informed manner. Asset Allocation is an important technique to help create an investment portfolio that resonates with your needs and expectations. We hope that this article helped you get a grip over the concept and inch towards becoming a better investor.
Disclaimer: This blog has been contributed by Quantum Mutual Fund AMC. The views expressed here are of the author and do not reflect those of Groww.
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