Personal Finance

The ABC of asset classes

B Venkatesh | Updated on January 24, 2018

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At most, three asset classes are enough, whether you are working or retired



Typically, your portfolio could contain four asset classes — equity, bonds, real estate and commodities. The need to have several asset classes is based on the principle of diversification.

But it would suffice if you have at most three asset classes in your portfolio, whether you are working or are retired.

How many assets?

Suppose you need ₹2 crore in seven years. Based on the amount you propose to save every month, you calculate that your investment should earn a compounded annual return of 5 per cent. You can invest simply in a recurring deposit and meet your objective.

But what if you require a return of 9 per cent or more? Investing only in a recurring deposit may not suffice. That is why you need to invest in equity. You have to take the associated risks to aim for a higher return.

The need for equity is the same whether you are a working executive or a retiree. As a working executive, you need higher return so that you can save less and spend more on your current consumption. As a retiree, the higher return on equity will help you meet your living expenses when inflation is higher than expected.

But consider real estate. As far as investment goes, real estate is land and building owned with the sole purpose of earning returns.

But there are two issues associated with investing in real estate. One, if you relocate to another city or country, it will be hard to ensure that your property is well maintained. And second, real estate is a lumpy and illiquid investment.

As a working executive, your portfolio’s portability should be aligned to your employment portability. So, if you are likely to relocate often, your portfolio should be in financial assets, as they are portable. But the argument is different if you are a retiree, or you are approaching retirement. What if your employer does not pay you pension?

You can invest in real estate to earn rental income to fund your living expenses. True, you can also generate monthly income from bank deposits and lifetime annuities. The advantage with rental income is that it partially adjusts for increase in price levels, as rentals keep pace with inflation.

Finally, take commodities — a highly volatile asset class that can generate high returns. But you are likely to buy only gold and not other commodities such as copper, zinc or crude oil.

But most of you buy gold in the form of ornaments. Now, such ornaments neither have a higher resale value nor do they generate any income.

You could, of course, buy financial gold (gold ETFs or gold funds). This could indeed be part of your portfolio. So, your portfolio could carry three asset classes if you are a working professional.

Diversification argument

You should necessarily consider equity and bonds in your portfolio. Consider gold if you are a working professional, or real estate if you are a retiree, only if it fits with your life goals.

But remember that during extreme events or financial crises, all asset classes typically crash. Your objective is to improve your chances of achieving your life goals. In the end, you have to keep your portfolio simple.

A two asset-class portfolio will suffice. A three asset-class portfolio may not hurt. A four asset-class portfolio may not be necessary.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in

Published on July 19, 2015

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