What is the most effective way to invest? There are few who think that it is all about timing the market. Others think it is about staying with your investments for the long-term. But the real answer is “asset allocation” or selecting and holding on to the right mix between different asset classes.
Asset allocation is basically dividing your savings into various asset classes whether equity, bonds, cash or other alternatives such as real estate.
A few FAQs:
Why is asset allocation important?
All asset classes do not move in the same direction at the same time. There are time periods when equities do well and others don't. At times bonds will do better than equities. As it is not easy for an investor to predict which asset class will fare the best at any given point of time, you spread out your investment between asset classes to capture performance trends in all of them. That helps you diversify and reduce the risk of downside. It also ensures that your portfolio value has a much smoother ride.
What is the right asset allocation?
The process of determining the mix of assets to hold in your portfolio is a very personal one. However the asset allocation that works best for you depends largely on your financial goals, time horizon and your ability to tolerate risk. The accompanying table is a brief indicator of which asset class would fit which goal.
Should I invest directly or take the mutual fund route?
There are many who ask: “Why should I pay a fee to someone else to manage my money when I can do it myself? All I have to do is read few magazines, watch a few TV channels, read a few reports and I am ready to make my own investment decisions.”
However, if you are planning to deploy your surpluses to meet your long-term goals, you need to find a specialist who will manage your assets across asset classes. After all, if you have a simple headache, you can go to a chemist's and buy a pain killer but if you have regular chronic headaches, then you will have to seek the advice of a specialist, isn't it?
Mutual funds offer convenient and cost effective ways to manage your assets. At very low charges of 0.50-2.25 per cent a year, you get to hire services of a professional investment manager whose job it is to manage and safe-keep your funds. Today, mutual funds offer products across the time horizon and risk spectrum. Whether you want to meet your short-term goals by investing in short-term funds or meet retirement dreams by investing in equity funds, mutual funds offer them all.
Should I change my asset allocation?
Yes, your asset allocation should be reviewed at regular intervals, preferably every quarter or six months, and may require changes for a few reasons — favourable markets can skew the allocation towards a particular asset class, there could be a new addition to the family or a significant change in your lifestyle. Asset allocation should keep pace with your changing needs and age. As you grow older, your capacity to take risk reduces; that too will require changes to allocation.
Finally, let us conclude with a small real-life example on the importance of asset allocation: In early 2003 I met an individual and based on his goals and risk-taking ability recommended and implemented an asset allocation of 20 per cent in cash, 20 per cent in bonds and 60 per cent in equities. We also decided to review the allocation every six months.
From 2003 to 2007, due to booming stock market, his equities valuation increased so much that this asset allocation changed to 80 per cent equity and 20 per cent in cash and bonds. In the second half of 2007 after reviewing the portfolio, I recommended that he sell 20 per cent of the equities and reinvest in debt, to get back to the planned allocations. Due to market euphoria, the investor not only ignored my advice but also cashed out on his bonds and invested the entire sum in equities. The result: a massive portfolio loss in the market fall.
I will conclude with the point that whether it is with investments or anything else in life, the right balance is the only way. Ignore temptation and follow what is right for you, and nobody can stop you from meeting your goals.
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