All you need to know about Asset Allocation
Things you always wanted to know about asset allocation
Imagine that you have a pizza in front of you. But the pizza has six different types of toppings with different crusts. Would not that be awesome?
Now think that the pizza is your investment portfolio with different assets. This is called asset allocation, which describes where you have put your money. Although there is a high probability that you will like all the different pizza slices, in case of investment, you need to be sure about where you have put your money and in what proportion. We don’t want you to invest blindly in different assets just because your colleague suggested you.
Asset allocation is essential as it helps to reduce the risks associated with an investment option through diversification. Different asset classes such as equities, debt or commodities react differently to a particular event. While one asset may outperform during a specific time frame, other assets may underperform.
Here are some of the questions that you need to ask yourself to come to the right asset allocation.
When are going to need the money?
This question will determine which asset class you should put in money. If you are likely to need the money within 2 to 3 years, you can invest in conservative investment options such as debt mutual funds. It will be better to stay away from equities as the equity market can be volatile in the short run. But it has been historically seen that equity markets give attractive returns in the long term. Hence, if you won’t need this money for five years or more, investing a higher proportion in equities would be the right approach.
What are your financial goals?
In addition to your timeline, your financial goals are also essential to determine your ideal asset allocation. For your short-term financial goals, debt mutual funds such as liquid funds, ultra-short term and short-term funds are good investment options. Invest in pure equity funds for your long-term financial goals.
How much risk can you take?
What will be your reaction if your investment value drops by 15% in a single day? If you are okay seeing your portfolio swing from one extreme to another, you can digest volatility; equities will be a better investment option. However, you can minimise the risks associated with equities by taking the mutual fund approach. High-risk investment options have the potential to give higher returns.
Now, that you have answered the questions, you begin thinking about allocating your money among the different asset classes. According to a thumb rule, your equity allocation should be 100 minus your age. E.g., if you are 25, 75% of your portfolio should be in equities. The younger you are, the higher should be your equity proportion. As you grow older, you can add more debt instruments or cut your equity proportion. It is because as you get older, your risk taking capacity also decreases.
It is also important to keep a specific proportion of your investment proportion (at least three months) as liquid cash for emergency purposes.
These were a few basics of asset allocation. But asset allocation does not stop with equity, debt or cash. Sophisticated or seasoned investors can include alternative investment funds in their portfolio. It is becoming a popular asset class among HNI and UHNIs. It has the potential to deliver higher risk-adjusted returns. Alternative investment funds include start-ups, private companies and hedge funds among others.
Among precious metals, gold is used as a hedging instrument. Gold performs better when the equity markets are in red. Geopolitical tensions and continuous rupee depreciation has made gold one of the must-haves in the investment portfolio of HNIs. However, ideally, gold should not constitute more than 5% of the investment portfolio.
Real estate is another asset that investors can look at to diversify their portfolio. Besides investing in real estate, investors can now invest in real estate investment trust(REIT). Through REITs, investors can invest in high-end commercial real estate.
Conclusion: Coming up with the optimal asset allocation may not be an easy task as there are various factors at play. Prudent asset allocation can help you to achieve your financial goals, fetch maximum returns, minimise risks and have sufficient liquidity. If you are not sure where to begin or need further clarity, your financial advisor will be able to help you out.
Why & How To Diversify Your Portfolio?
Diversification is investing in investment options to limit exposure to any particular asset class or investment. This practice helps to reduce the risk associated with your portfolio. Simply put, diversification helps you to yield higher returns as well as reduce the risk in your portfolio. Balancing your comfort level with risk against your time horizon is one of the keys to a long successful investing journey. For e.g., keeping pace with inflation may not be easy if you start investing in conservative investment options from a young age. On the other hand, taking a large exposure to high-risk instruments near retirement could erode the value of your portfolio. Hence, it is important to balance the risk and reward in your portfolio so that you don’t lose sleep on market ups and downs.
What are the components of a diversified portfolio?
The major components of a diversified portfolio are equity, debt and money market instruments.
Equity investments carry the highest risk in your portfolio and it has the potential to give higher returns over the long run. But with higher return comes greater risk especially in the short run. Equities tend to be more volatile than other asset classes. Investing in equity mutual would be the best way to take exposure in equities. Equity mutual funds are diversified funds as fund managers invest in different stocks and across sectors (except sectoral funds) which optimizes the risk in your portfolio.
Another important component of a diversified portfolio is debt securities. While equities have the potential to grow your wealth, debt investments provide stability and act as a cushion through the market cycles. Debt instruments include debt mutual funds, fixed deposits, bonds etc. The main objective of debt instruments is not to provide high returns like equities but capital protection along with inflation-beating returns. Debt investments can also be a source of income.
While equity investments give higher returns and debt instruments protect the capital to help us fulfil our financial goals, a part of the portfolio should be in liquid and money market instruments such as liquid mutual funds or a separate savings account. It provides easy access to money during emergencies such as job loss or accident.
Why is diversification important?
Diversification helps to minimise the risks associated with your portfolio. Let us assume that two years ago, you had invested your entire savings in a particular airline stock. Now, the airline is near bankruptcy and the stock price went down 60% in one month. Would you be comfortable in that kind of scenario? Most people wouldn’t. You would have less stressed out if you had diversified your portfolio and invested in a few other companies rather than taking 100% exposure in one particular stock.
Diversification is important because different investment options react differently to the same development or move in a different pattern. For example, real estate and gold tend to underperform when equity markets are soaring. A cut in the interest rate may benefit the bond market but may not be good news for individuals with fixed deposits.
How to diversify your portfolio?
Diversifying your portfolio is as healthy as consuming green leafy vegetables, fruits, exercising and meditating on a regular basis. However, eating just one kind of fruit may not be very effective. Hence, it is important to diversify. Investment is no different. Here are some of the ways through which you can diversify your portfolio:
Spread your investments among different asset classes:A diversified portfolio should include equities, debt and cash. Exposure to international market and commodities such as gold can help you in further diversifying your portfolio. It is because different investments come with different risk and returns. Higher the returns, higher will be the risk and vice versa.
Diversify within individual types of investments: Diversification is also necessary within an asset class. For e.g. in case of equity mutual funds do not concentrate on one category. It is recommended that you have mutual funds across market capitalisation such as large cap funds, mid cap funds and different investment strategies. Different funds and stocks come with varying risks thus minimises the risks.
Rebalance your portfolio regularly:Diversification is not an one-off exercise. Rebalancing your portfolio depends on two important things which are the number of years until you expect to need money(time horizon) and risk-taking capacity(risk tolerance).
To summarise, diversification is important for every investor whether it is across asset classes or within an asset class. The nature of diversification depends on financial goals, time horizon and risk tolerance. It is also important that the diversification of the portfolio is updated on a regular basis.
Should you invest in debt mutual funds or FDs?
Capital Safety, the rate of returns, the lock-in period and taxation are some of the key features that can help you select between debt mutual funds and fixed deposits.
When it comes to investing, for many of us safety comes first and returns come second. After all, no one wants to play gamble with his or her much hard-earned money. Hence, fixed deposits and gold became our favourite investment options. In this craze of safe investment options, we forget that fixed deposits may not be the most ideal investment option.
However, for investors whose priority is capital safety along with inflation-beating returns can look at debt mutual funds. Debt mutual funds are a category of mutual funds that invests in fixed-income securities issued by various companies and governments.
Now, let us understand the difference between debt mutual funds and fixed deposits that can help you to compare the two investment options and choose your pick accordingly.
Interest rate/Rate of returns
Return from Fixed deposits are fixed and are in the range of 7% to 7.5% currently. While interest rates remain the same during the fixed tenure but it may change through the years. Hence, when you want to reinvest the fixed deposit’s maturity amount, interest rates might be different at that time. With the interest rates moving south, banks may trim the interest rates on deposits going forward.
On the other hand, the returns on debt mutual funds are not assured and are linked to the debt market. Debt mutual funds have the potential to deliver higher returns than fixed deposits as fund managers make investment decisions based on the current debt market scenarios and select papers based on credit ratings and internal research. The expected returns from debt mutual funds are normally the Yield to Maturity minus expense ratio if one remains invested till the duration of the fund keeping all other parameters the same. Also, debt funds stand to gain from the lowering of interest rates as the price of a mutual fund unit i.e. net asset value rises when the interest rate falls.
Debt mutual funds have the potential to generate higher real returns. Real returns are the returns given by an investment option above the inflation rate. E.g. if the average rate of inflation in that year was 5% and the interest rate on fixed deposits was 7%, the real rate of return is 2%. A higher real return helps in fulfilling financial goals.
When it comes to capital protection, bank fixed deposits have an edge over debt mutual funds. However, fund houses cannot guarantee capital safety. In the case of FDs, capital protection differs from the issuer of fixed deposits. Non-banking financial companies give higher returns on fixed deposits but it also comes with higher risk than a bank deposit. Though capital erosion risk is very less in debt funds as the portfolio consists of well-researched securities and also due to diversification.
Fixed deposits have a maturity period and you have to pay penalties if you want to redeem your fixed deposits before the maturity date. However, you can redeem from your debt funds anytime you want. However, a few debt funds may have exit loads if you redeem them within the specific time frame. Hence, debt funds are more liquid than fixed deposits.
Taxation: The taxation structure of debt funds is better than fixed deposits as it comes with indexation benefits. There are two types of taxation on debt mutual funds i.e. short-term capital gains and long-term capital gains. Short-term capital gains are applicable if the units are redeemed before three years and gains are taxed as per the income slab. If you stay invested for more than three years, you are eligible for long-term capital taxation at 20% with indexation. Indexation is nothing but accounting for the rise in inflation. In this case, you only pay tax on gains if the rate of returns is higher than the inflation rate. However, in the case of FD, the entire gains are taxed according to the tax bracket of the investor.
Conclusion: Debt mutual funds are a good investment option if you are looking for a relatively stable investment option along with inflation-beating returns. Investors who are in the higher tax brackets can also look at debt mutual funds for tax-efficient returns.
Should You continue or stop your SIP?
Recently the data published on one of the new websites said that 'New SIP growth falls 61% from April to December.' What does it mean? Does it mean that investment through SIPs is no longer attractive? Does it mean that Investors are moving away from SIPs?
There could be only two reasons for the fall in Net SIP growth. The number of New SIP registration is slowing down and another reason may be that some investors are stopping their existing SIPs.
Historically it is observed that people start SIPs when the past performance looks good. When the market is in bull run people start an SIP expecting the similar return in the future. But the market can never go up in a linear fashion. There are going to be ups and down. Volatility is the part of the stock market. So when the market corrects and the return in the portfolio is negative or not as per expectation people stop the SIP and book the loss.
Remember! In the long run, correction is temporary and growth is permanent. But when you press the panic button and stop your SIP your temporary loss gets converted into a permanent one.
Creation of wealth through SIP requires two elements in place; first good financial advice and second discipline. Returns from SIP are never going to be proportional every year. There would be a few volatile years before you create a wealth. Those are the years where Investors need to stay disciplined and stay invested. In fact, if you want to become an even smarter investor you need to increase your SIP amount or add more money to your existing SIP folios. That would help you to accumulate more units and when the market recovers your portfolio would grow even faster.
If you had started a SIP of Rs 10000/month in September 2010 in a large cap fund (There were 43 Large Cap funds available), the value of your investment of Rs 3,60,000 after three years would have been Rs 3,48,896. Many investors were in a panic and stopped their SIPs due to this negative return. But for those investors who continued their SIP for even one more year, the value of their investment of Rs 4,80,000 was Rs 6,99,858/- after the fourth Year.
The market is always going to test your patience. If you lose your patience, you shall not be able to create wealth. Remember what legendary Warren Buffett has said when you are losing your patience, "Successful Investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can't produce a baby in one month by getting nine women pregnant."
Importance of Portfolio review
While investing for any specific goal, we always assume some rate of return from the investment based on some rationale. Actual return may vary from time to time from the assumed return, so it becomes very important to check whether we are getting that return or not. We also need to check how various asset classes and schemes are performing in our portfolio. This exercise is known as review and it should be done on periodic bases. Ideally once in a year, you must review your portfolio.
Reviewing doesn’t necessarily mean frequent buying and selling based on performance. The return which we assume is for the CAGR return for the entire period of investment and need not to be equal to the assumed CAGR every year.
How to review your mutual fund schemes:
You can review the performance of your scheme and compare it with the performance of the benchmark. Apart from the benchmark, you can also compare it with peer group performance.
The performance of a good scheme also may lag at some times, so short term performance should not be given too much of weight while doing the review of the portfolio. Rather than short term performance, you must consider long term return and consistency in performance.
Apart from the return you also need to compare your portfolio on other parameters like risk, risk adjusted return and quality of portfolio while reviewing the scheme.
If the scheme underperforms on all the above parameters you should exit the same and invest in some other scheme.
But, remember reviewing doesn’t necessarily mean buying and selling every time while you review. The decision of exiting should not be based on short term underperformance noticed during the review. You need to adopt a holistic approach of reviewing the scheme by taking into consideration of other important parameters also apart from short term return.
Once you know where you are going by setting appropriate investment objectives, your portfolio review will help you reach your destination. How? By identifying problems and mistakes that you can correct mid-course. Much like a pilot, your job is to stay on course so that you can reach your destination safely and in a timely manner.
Why you should stop looking at "Past Performance"
Have you ever got stuck up in traffic? I am sure you have. Just imagine your car is new brand with a powerful engine, but unable to move an inch because of heavy traffic. And you get what? Frustrated! What happens when you cannot move but the smaller cars in lane next to you are moving faster than you because that lane has lesser traffic than the one in which you are driving. More Frustration! Right?
As a human being, it is obvious that you would have a strong urge to change the lane and move to the faster lane. And using your driving skills you change the lane. The moment later the lane which you left starts moving and the new lane in which you entered stops moving due to traffic. Now what? Height of frustration!
If there is a smile on your face while reading this, it means you have already have experienced it, probably not just once but more than once you have changed the lane and mostly reached the height of frustration.
Not just driving whenever in our life when we see someone is moving faster than us we try to change the course and find ourselves caught in the trap and then feel like we should have stayed in our lane.
Changing Mutual Fund scheme based on Past Performance
So is the case with Mutual Fund schemes. Most investors after investing in mutual fund schemes start comparing the return of their schemes with that of other mutual fund schemes. And many a time we change the mutual fund schemes and switch our money to other better performing mutual fund schemes in the recent past. And what happens next?
In recent times, Past Performance has become a major criteria of the mutual fund selection system. Investing based on recent past performance is as risky as driving a car by looking only into rear view mirror. While driving, rear view mirror is useful but more than rear view it is your front view that is more important for smooth and safe journey.
Past track record definitely helps in understanding the quality of the scheme and the ability of the management team but recent past performance is not the guarantee for the future.
What else matters while selecting a scheme?
Apart from Recent past performance, one should look at the consistency of return which can be derived from rolling return analysis for various periods, which requires a lot of data crunching rather than just finding out the past one year return.
One should also look at how the fund has performed during the best and worst period in past compared to its benchmark and category return.
You also cannot avoid looking at risk parameters. If some fund is generating superior return then it is also necessary to check at what cost. How much risk or volatility is it adding to the portfolio.
Choosing a fund from a basket of hundreds of funds requires lots of data, analytical skills, education and experience. One can do it by own but it is very risky. It is always advisable to take the help of qualified professionals for building a quality portfolio and stick to it with discipline.
Frequently changing lanes rarely helps, in driving or investing.