Money.

It is at today's age one of the most powerful tools which gives an individual, purchasing power and helps fulfil ones Aspirations. As a civilization, we have come a long way since the Barter System and currency now symbolizes a medium of exchange in the modern era.

It is evident that earning money is extremely important, but to what extend should one be financially sound to manage one’s hard earned money so that he/she can not only preserve it for their goals but also generate decent returns from money through Investments.

In today’s environment, we are surrounded by numerous Investment options with parallel risk-reward ratio. In such cases, it becomes extremely important for an individual to maintain a decent asset allocation to negate any possibility of over allocation into any specific instruments and vice versa.

Asset Allocation in simple terms, is the implementation of an Investment Strategy that is put in place to balance risk versus rewards by having percentage allocation into each asset class in a portfolio based on client’s risk tolerance, goals and Investment horizon.

To dig deeper on the 3 important variables of Asset Allocation, risk tolerance is the first and foremost clog which needs to fit into the wheel of Asset Allocation. The risk profile determines the investors Ability and willingness to take risks. Both are very important parameters to determine the investors risk profile.

Second, is the Goals which may be different for different individual barring a few common ones like retirement.

Third is the Investment Horizon which is dependent on the timeline the Investor is looking to make-do with his investment and generate returns from the same.

Now that we have touched upon the basic elements of determinants of Asset Allocation, we can now look to review the benefits one can get from prudent Asset Allocation. Here are 5 points for a better understanding of the benefits:

1. Maintaining Consistent Portfolio Risk: With optimal percentage allocation, you can make sure that you do not over allocate your money in a certain Investment. Past experiences can easily influence your Investment decisions in the current scenario for which Asset Allocation is very important. With a positive experience, you can go overboard with Riskier Assets i.e. Equities and with bitter experiences you can over-allocate in Fixed Deposits and Fixed Income Investments. It is important to maintain asset allocation to meet your Goals with the given Corpus and Investment Horizon.
2. Market Cycles: A prudent Asset Allocation with well-researched Investment Products will help you in uncertain times and will effectively deal with market volatility. Investments like Liquid, Debt qualify as safer instruments in the overall portfolio and give steady returns to your portfolio despite a bear market. Inversely one can reap benefits from a bull market with allocations into Equity Mutual Funds, Direct Equities, Portfolio Management Schemes etc.
3. Optimise Returns: The expected returns from your portfolio is dependent on your risk profile which will determine your Debt: Equity Allocation in your Portfolio. For example, a risk profile having 50-50 allocation into Debt: Equity can expect a return in the range of 9% - 10% in the long run, wherein a risk profile having 30:70 allocation into Debt: Equity, can expect returns in the range of 11%-12% returns in the long run. (Assuming Debt gives 8% and Equity 12% in the long run). Note: The return percentages are Pre-tax.
4. Liquidity: Liquidity is one of the vital factors in making investment decisions due to some instruments having certain lock-in periods. A prudent asset allocation model will help you meet your liquidity needs as and when a goal is reached. The model also accounts for an allocation into Liquid Funds which can act as a buffer in times of contingencies.
5. Time Horizon: The time horizon is a key indicator to determine the asset allocation in order to achieve one’s financial goals. With a longer time horizon, you can always tilt your Investments towards equities and less towards debt. Equities show better consistency in the long term while coping with market volatility in the short term. Fixed Deposits on the other hand are deemed as safer instruments, but the after-tax returns do not beat inflation. Hence, a combination of Debt and Equities work exquisitely well in the long run.

To put things into perspective, there are primarily two types of Asset Allocation:

1. Tactical Asset Allocation: The Tactical Asset Allocation strategy is used to match the present market conditions. In a Bear market, allocation into Equities and risky asset can be higher and similarly in a Bull market, one should look at opportunities to book profits and park funds in safer instruments for the reverse cycle to play out.
2. Strategic Asset Allocation: The Strategic Asset Allocation adopts an allocation mechanism where the actual allocation of individual asset classes matches closely with the recommended percentage allocation of each asset class as per the risk profile. The deviation in each asset class much not exceed 5% of the recommended allocation. This allocation can be achieved in a time frame of 3-5 years from the start of the investment period for an investor.

It is important for an investor to build strategic allocation in the long term as per the risk profile with some tactical asset allocation steps based on the current market conditions. This requires Investors to maintain a discipline and be patient with their portfolios.

Coming back to the most Important Question, what is the optimal Asset Allocation for an Investor?

The First step is Risk Profiling exercise that provides information on the Risk Appetite and Risk Capacity. I am giving an illustration of a strategic Asset Allocation of 50:50 between Risk Type and Non-Risk Type Assets for a Moderate Risk Profile. (Note: The Debt Equity Allocation for Moderate Risk Profile can vary for different models).

*It refers to instruments not adhering to standard Equity and Debt Mutual Funds that considered as a part of Equities.

** This includes FDs, PPFs etc.

Important: The percentages mentioned in the above table adheres to the strategic asset allocation. The percentage recommendation into each asset class is not definite and can be adjusted based on advisory models. This is an example and readers are advised to take professional help to determine exact asset allocation suitable for their requirements.

Lastly, it is commonly observed that people tend to have higher allocation to illiquid Assets like Real Estates in one’s asset book which is fine if it is primary residence or property adhering to emotional connect. Having multiple illiquid properties can lead to liquidity constraints in the long run. Hence, it is always recommended to have assets which can be liquidated easily to meet any contingencies, goals and even make use of the funds for tactical allocation in the markets.

To summarize, once prudent asset allocation is in place, you can be rest assured that one can optimize his/her portfolio returns, minimize risk and have enough liquidity to achieve their financial goals. One can always have a complete overview of one’s financials through Financial Planning and can re-align their allocations based on the recommended percentages, but Asset Allocation is the mantra to keep your portfolio afloat in a Bear market and generate decent returns in the long run.

The same methodology is validated by the great Investor, philanthropist and a business tycoon, Warren Edward Buffet and I quote his words, “Do not put all eggs into one basket”.

Author

Rahul Saha is the author of this article. He is a Senior Wealth Manager at Mitraz Financial Services Pvt. Ltd. The author can be reached at micontact@mitraz.financial.

Disclaimer

The entire contents of this article are solely for information purposes and have been prepared based on relevant provisions and as per the information existing at the time of the preparation.

It doesn’t constitute professional advice or a formal recommendation. The author has undertaken the utmost care to disseminate the true and correct view and doesn’t accept liability for any errors or omissions.

You are kindly requested to verify & confirm the updates, if any, from genuine sources before acting on any of the information provided hereinabove.