Guide To Investing In Stock Market (Part V)

Importance of Asset Allocation

It is important to save but more important to invest your money. By merely stashing away money into that neighborhood bank’s savings account, you are neither making any more money, nor preserving its value. Let apart the cost of better opportunities foregone. The purchasing power of rupee keeps depreciating. So, to fight against such depreciation one has to invest the money saved in assets that will help it work for you and earn more than the erosion in value through inflation over a period of time. Another more definitive reason to invest is the ‘Power of Compounding’. Put simply, it means "Interest on Interest is Interesting".

Before setting out, you need to know the investor within you. Are you aware that the nature of investment differs from individual to individual and is unique to each one because it depends on various parameters like our future financial goals, the present & the future income model, our capacity to bear the risk, the present requirements and lot more. While investing, you should know what you need to do to reach your destination and how accountable you have to be on your way there. In fact, to set off on your investment journey without knowing the following can prove to be extremely disastrous.

1. How much return do you expect on your investments?
2. What kind of investor are you?

To start a journey without determining the above two is like the blindfolded maneuvering in a vast ocean, hopelessly trying to reach the destination. The investor can be of three types depending upon his financial status and risk appetite. He can be a conservative, moderate or aggressive. The more equity allocation a person has in his portfolio, more aggressive he is considered. The aggressive investor will have a high return expectation and also would have a high-risk appetite i.e. willing to suffer losses. The moderate investor will have somewhat a balanced kind of a profile with a 50% equity exposure and a 50% debt exposure of his assets. He can take moderate risk and wants to keep his capital intact. The conservative investor will have a huge debt exposure. His returns expectations are low and he just wants to have small returns but keep the capital fully intact.

Given the wide range of investment options available today, making a right investment decision is not all that easy. Fixed deposits, Bonds, Debentures, Stocks, Mutual Funds etc, present a complicated puzzle, which a layman finds difficult to understand. All this results in delaying the investment decisions thereby eroding the value of your hard-earned money. It’s here that the importance of asset allocation really emerges. Simply put, asset allocation, as the name suggests, involves determining the right balance or mix of your investments into various categories called asset classes (call them vehicles if you want). Most of you must have heard the mention of one or all of these three basic classes: Equity, Debt and Cash.

The essence of asset allocation lies in the fact that, over time, it can determine up to 90% of your portfolio’s return. For this reason, the right asset mix is one of the most important financial decisions you have to make. Ironically, investors spend more time deciding on individual stocks or bonds (security selection), than they spend in choosing between equity, debt and cash (the asset allocation).

Investors should periodically review their asset allocation across different assets as the portfolio can get skewed over a period of time. This can be largely due to appreciation/depreciation in the value of the investments. For example: an investor who had invested Rs. 60 into equities out of his Rs. 100 and balance in income funds for one year and during the year, the equity market appreciates by 40% while the debt markets grow by 10%. At the end of one year, his Rs. 100 will be Rs. 117 and his asset allocation would be 72% into equities and rest into debt – equity exposure would have gone up by 12% (due to appreciation in stock indices). An investor who wants to keep the allocation at 60% should reduce the exposure in equities and shift to debt. This is called portfolio rebalancing. Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each asset class back to its original state. In addition, if an investor’s investment strategy or tolerance for risk has changed, he or she can use rebalancing to readjust the weightings of each security or asset class in the portfolio to fulfill a newly devised asset allocation.

However, it needs to be understood, that no matter what type of portfolio one go for, it’s important to review ones portfolio regularly to assess the progress. Further, as an individual go through different life-cycle stages, one would need to rebalance the portfolio to try and match the investment mix to life-cycle stage and ones investment goals.

Asset allocation decides 70%-80% of the returns over the long term and defines risk for the portfolio. Security selection is secondary and decides only 20-30% of the returns over the long-term.