The Hindu Business Line : Make assetworthy allocations

You have just landed your first job fresh out of college. It is an exciting time, full of promise... you have your whole future ahead. But let's face it — setting priorities on a limited income can be frustrating, especially when you do not know how long you may be working in your first `real job'.

Your priorities now may include clearing the education loan, buying a car, saving for a home, or planning your marriage. Also, focussing on retirement planning, as soon as it is possible, makes it easier to accumulate funds for the future.

As people say, "Cricket is a simple game: You throw the ball, you hit the ball, and you catch the ball." The same can be said for investment management too:

Determine how much money you need to accumulate, and by when.

Given your current and expected future savings, determine the minimum rate of return you need to earn on your portfolio to achieve your financial goal.

Decide on an asset allocation strategy that maximises the probability of achieving this goal at the least possible risk.

Select investments to implement this strategy.

And check your performance at appropriate intervals to make sure you are on track to achieve your goals.

This approach differs from others as it starts with your goals and risk tolerance (which, in turn, determines your asset allocation strategy), and proceeds to tell you how much more you must save.

How Much should You Save?

One of the surest ways to cause an anxiety attack is to ask someone (or yourself), how much he needs to save for retirement.

The slight sense of panic most people feel when they hear this question is triggered by a combination of three common underlying fears: That we may outlive our retirement savings; see our purchasing power eroded by inflation, and/or we may not end up leaving as much money to our heirs as we'd like.

Asset Allocation and Rate of Return

Asked to define "asset allocation", most people said that it has something to do with the way you divide your investments between different groups of similar assets.

Ask your friends to identify the different asset classes under which they have considered investing. You are almost certain to hear answers that include "growth stocks", "value stocks", ``bonds'', "small caps", "mid caps", and occasionally "international stocks".

The returns of such investors have a relatively high degree of correlation with one another, which makes all of them members of the same asset class — domestic equity. Broadly, they fall under not six, but just three different asset classes — Domestic equities, international equities, and bonds.

Further, "bonds" or "domestic bonds" refer to not one, but at least three asset classes: Real return bonds (that protect you against inflation); investment grade bonds (that protect you against deflation); and high yield bonds. The same is true of "international equities".

This could mean developed country equities from Europe or the Pacific Region, or emerging market equities. While the actual allocation of your portfolio to different asset classes is important, the definition of the asset classes you consider is equally critical.

How you choose to allocate your investments between different types of assets is the most important decision to make when it comes to determining whether or not, over time, you will earn the minimum rate of return you need to meet your goals. Unfortunately, most people do not spend enough time thinking about this decision before they make it.

Now, how important is the allocation of your assets between different classes? Consider two investors who have to answer two questions: How to allocate their portfolios between three asset classes, and whether to implement this strategy using index funds or actively-managed funds. There are four ways to answer this question, and they are all correct.

If the two investors choose different asset allocations, but both implement their strategies using the same index funds, then asset allocation accounts for 100 per cent of the difference in the returns they achieve after ten years. Similarly, if they have the same asset allocations and implement them through the same index funds, asset allocation again accounts for 100 per cent of the returns they achieve.

On the other hand, suppose they both have the same asset allocations, but choose different actively-managed funds to implement their common strategy, then the asset allocation would account for zero per cent of the difference in the returns their portfolios achieve after ten years. All of the difference would be due to some combination of manager selection (by the two investors), stock picking skill (by the portfolio managers of the funds each one invests in), and the costs and taxes incurred by the respective funds.

The far more difficult situation is the fourth one, in which the two investors have different asset allocation strategies and choose different actively-managed funds to implement them.

So, in most cases, asset allocation is likely to be the key determinant of the portfolio's long-term rate of return.

(The author is CEO, Financial Planning Standards Board India. The views are of the author and not that of the organisation.)

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