by Om Ahuja/ETBB
I have hardly met any individual till date, who has managed to build an ideal portfolio with an ideal asset allocation. Most individuals are driven by the herd mentality and invest in products/stocks that have delivered exceptional returns in the past. The greed factor largely drives the investment strategy.
Warren Buffett rightly said, “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” Very rarely do investors sit down to create an ideal balance for their portfolio by maintaining an exposure consistent to their risk appetite. The diversification procedure is the spinal cord of the investment philosophy, because it efficiently protects the individual against being overly exposed to any particular asset class. It helps create an average overall return generated by the performance of multiple asset classes, thus diminishing portfolio risk. Each asset class (i.e. equities, bonds, cash, gold and so on) has different characteristics.
Equities, for example, have the potential to provide higher returns, while bonds may provide lower risk along with regular income. Since different asset classes do not move in tandem, i.e. when one asset is down, the other may be up. This may help in lowering the investment risk across the portfolio. The goal of asset allocation is to achieve the highest return at a particular level of risk.
Diversification across asset classes balances investments with higher levels of safety with those that have higher levels of growth. Diversification also offers the additional benefit of countering the negative effects of various economic or market conditions, by combining investments, which behave differe n t l y w h e n exposed to those conditions. The adjacent graph reflects various investment choices according to the risk-reward relationship. The classification of risk as low, moderate or high depends on the perspective of the investor and age. In a sense, risk is in the ‘eye of the beholder’. Careful analysis is the best way to choose investments. Determining the right mix is possible if you have answers to few questions such as: what is your investment horizon; what are your investment goals; cash-flow schedule and requirement will help you in building the right asset allocation with the right mix of products.
Age plays a crucial role in portfoliobuilding, risk appetite reduces with increasing age and responsibilities. As you grow older your income levels keep moving northwards but your savings keep moving southwards as your needs and expenses keep rising along with inflation. During the early part of your career (till the age of 40 years) the primary objective of an individual is to invest in basic necessities for living like mobile phone, car, flat and the list goes on. Your investments are restricted to statutory investments most of the times to save tax. Investments into provident fund, insurance policies and deposits are standard investments in this age group. Investment into equities and equity mutual funds gradually catch-up. Ideally investments into equities with long-term investment horizon help in giving a fillip to portfolio return. It has been historically proven that equities as an asset class, over a long-term horizon beat inflation and returns from any other asset class.
You need a well-formulated investment strategy and a disciplined approach to manage your equity portfolio, as the total risk of investing into equities is that you can lose a maximum 100% of the principal invested. However, the upside, on the other hand, is unlimited. After 40 years of age, capital appreciation remains an important objective for individuals. Therefore, a more conservative asset allocation with higher tilt towards fixed-income bonds and postal schemes start happening. Exposure to equities creates balance and helps in increasing portfolio returns. After 50 years of age, as one approaches retirement, you will probably be more concerned with a steady income at low risk. Increasingly at this age a sizable component of savings is used up for children’s marriage and in educating them. This merits reviewing and re-balancing the portfolio and helps in ensuring the performing asset class doesn’t get liquidated before its intended maturity. After retirement, the focus is on a steady income to meet day-to-day needs.
With a limited medical cover at this age and no forthcoming regular income, the investments made in the span of 40-50 years of age starts bearing fruit. Equity exposure remains minimal and at times more for balancing the inflationary pressure. Asset allocation is not a one-time exercise. Over time your lifestyle will change, as will your economic situation. Reviewing your asset allocation, and possibly making changes to it, should be an exercise carried out at least once a year.
You may need to rebalance your portfolio to maintain diversification within your risk tolerance profile. Ideal asset allocation cannot be built overnight as it is a process that matures with time, experience and options.
(The author is head, investment advisory, Yes Bank)
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You should invest in a business that even a fool can run, because someday a fool will. – Warren Buffett