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Many people are terrified of investing because of the number of tough decisions they need to make. Should they start investing in equity funds when markets are high? Should they book gains on stocks and put the money in a FD? Should they buy small-cap funds?
You may get swamped by such decisions and make wrong ones, if you don’t have a framework for them. That framework is called asset allocation.
Hi, I’m Aarati Krishnan. In this episode of Question of Money, I’m going to talk about asset allocation, which is one of the most important decisions in financial planning.
What is it? Most people spend their time agonising over which stocks, mutual funds or bonds to buy. But they neglect asset allocation, which makes all the difference to their long-term wealth - asset allocation.
What is asset allocation? It is the decision on how you will divide your investments between different asset classes – stocks, bonds, real estate, gold and so on. So if you have Rs 100 to invest, asset allocation tells you whether you will divide it 70:30 in stocks and FDs, 50:50 in stocks and bonds, or 50:40:10 in stocks, bonds and gold.
The main purpose of such division is to control risk in your portfolio and to avoid hasty decisions driven by greed or fear which are the biggest enemies of wealth creation.
Suppose you have Rs 10 lakh in a 100% equity portfolio, a 25% market crash will wipe out Rs 2.5 lakh. On losing so much money you may panic and be tempted to sell the remaining Rs 7.5 lakh. That would be absolutely the wrong thing to do as a bear market is a time to buy and not sell equities. If you have only a 50% allocation to equities though, you will lose only Rs 1.25 lakh and the impact on your overall wealth will be limited This can save you from panic and make you hang on to your stocks when you should.
Rebalancing is one of the most useful concepts in asset allocation. It says that if your exposure to any asset exceeds your allocation, you should sell it and buy into the asset which has low weights. This is called rebalancing. It takes all emotions like greed and fear out of your investing decisions and prompts you to buy low and sell high.
How to decide on your asset allocation
There is no one ideal asset allocation plan that will work for everyone. The kind of asset allocation you have should be based on the following:
Your age: Younger you are, the higher allocation you can afford in risky assets like equities. This is because you have the ability to wait out any corrections or losses
Your holding period: For financial goals coming up in less than 3 years or 5 years, debt options are more suitable than equities. For long term goals like retirement, equites are best.
Your liabilities: If you have a lot of EMIs to service, your risk appetite tends to be lower. This means less allocation to equities
Your family situation: If you have a lot of dependents to take care of and may need to withdraw from your investments often, equities may not be suitable
Your risk appetite: Your long term investments must not give you sleepless nights. Some people cannot tolerate even a 10% fluctuation in their investment value. Others can sleep through 50%. So gauge your risk appetite, your ability to take losses and then fix your asset allocation.
What if you don’t have a lot of time to run though this list and create the perfect asset allocation framework? Don’t discard asset allocation altogether. You can simply decide on an asset allocation between safe and risky investments or equities and debt, and leave it at that. Start with a 50:50 or 60:40 allocation and improve it as you go along.
(Host: Aarati Krishnan, Producer & Edits: Anjana PV, Camera: Bijoy Ghosh and Siddharth Mathew Cherian)
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