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Top Down, Not Bottom Up

Choosing the right type of investment is far more important than the actual investment product...

When you want to know where to invest your money, the worst question to start off with is the obvious one, that is, “which investment should I choose”. That sounds paradoxical-after all, if you want to choose make the right choice of say, a mutual fund, then you'll have to ask which one. However, if that's the question then there's practically no chance of getting the right answer. Unfortunately, the way financial investments are sold, this question is presented as the first and the most important one to ask. The right question to ask is “What type of investment should I choose in”? That's because choosing an investment is not a bottom-up activity but a top-down one.

The process of deciding how to invest your money consists of layers of decisions. At the top layer, one has to figure out the general mix of asset classes such as equity, fixed income, real estate and such. This mix depends on your time-frame, risk-taking ability, need for income, age and such broad measures. At the next layer, you need to decide what kind of investments should make up each of these.

For example, should the equity be equity mutual funds or direct investment in equity. Should the fixed-income investments be a bank FD or a post office deposit? The decisions you take at this layer are probably more driven by convenience and knowledge rather than by your needs. It's only at the next layer, do you decide which actual investment should the money go into, such as which fund or which stock and so on.The importance of thinking in these asset allocation layers is that making the right decision at a higher layer is far more important to your financial health. However, the advertising hype and the salesmen's pressure is all focussed at the final product-choice stage. If you listen to the noise, then you could end up choosing a product of the wrong type, whereas if you have already chosen the right type, then the chances of making a damaging decision is minimised.