Plan your work and work your plan. In seven words, this sums up one of the best ways to be successful in life. And as investing is one of the important parts of our working life, this strategy can be extended here too. And as all good things in the investing world come in nice small packages, so does this plan. In investing jargon it is called asset allocation. This complex sounding terminology is all about having a plan. It is also about how to continuously manage this plan.
Asset allocation is a simple way to reduce risk by spreading investments across different asset classes. It is also about spreading your investments over time while factoring in your financial requirements.
Asset allocation is based on the fact that different asset classes tend to behave differently. Thus while equity is volatile in the short-term over the long-term, it delivers the highest returns among all asset classes. Debt instruments on the other hand are very stable but they cannot beat inflation over the long-term. A combination of these asset classes as compared to exclusive investment in any one can give the best of both worlds. In case of sudden need, debt instruments can be liquidated with minimal losses. Over the long-term, equity can boost returns.
Asset allocation helps in avoiding efforts to time the market. Financial markets are impossible to predict with any degree of consistency and accuracy. One cannot say which asset class will perform and when. In the past two years, debt funds have given 15 per cent plus returns. In equity funds, you would have lost 19.33 per cent in 2001 and 26.66 per cent in 2000. Gold has recently touched an all-time high. Just as good times cannot be foretold, neither can bad times. The crash in equity markets post-9/11 and the current uncertainty are the best examples of this. According to Peter Bernstein, "Surprise in investing is inescapable, not an accidental anomaly. Capital markets are always assailed by uncertainty." If we accept this, the best thing to do is to be prepared by allocating between assets with different risk-return characteristics.
When an investor is young and with few liabilities, risk taking ability is at its highest. As one approaches middle age, liabilities tend to increase. Your risk-taking ability diminishes. Children's education, insurance and owning a home take precedence. Consequently, equity allocation should be less. After retirement, the lack of a salary severely curtails the ability to regularly invest. However, lumpsums received from provident funds and other sources have to be deployed to generate a steady income. Risk-taking ability is minimal at this stage. Preservation of principal is usually a pressing concern. Equity funds can be used to give a boost to overall returns. As returns from fixed income instruments have fallen over the past few years, the only way to boost returns is to veer towards equities. But this brings with it a whole new world of risks. In such a scenario, it is essential to understand one's ability to take risk.
And much of this flows from examining the existing financial status, earning potential and financial goals. An asset allocation programme factors in these requirements, thereby providing a personalised investment strategy. It is the most crucial step, which must be taken before contemplating any investment.