Mohan recently started working with a multinational FMCG company after completing his management degree. Always striving to be independent and a self sustained individual, Mohan wanted to start investing for his future needs without relying too much on his family. Mohan wanted to invest some part of his earnings for his weddings related expenses as well as for his future life. The large number of investment options made Mohan confused. Everyone he asked for help suggested a different investment strategy. While his parents vouched for a fixed deposit investment which was secure and offering assured returns, his colleagues vouched for mutual fund investment. Some of Mohan’s friends suggested that since he was young and had no responsibility on his shoulders to sustain other people, this was the right time to invest in the high risk equity market.
Many of today’s investors face this dilemma of choosing the right asset allocation for their investment. One of the many fundamental reasons why a lot of investors fail to reach their desired goals and returns is the wrong selection of asset allocation for their investment. What may work for one individual may not be the best case scenario for the other. Asset allocation needs to be looked at for each individual differently keeping in view a number of factors.
Let us look at the idea of asset allocation, its advantages and tips to choose the right asset allocation for each individual investor.
Understanding Asset Allocation:
Choosing the right investment vehicles for one’s investment portfolio is known as asset allocation. One of the easiest ways to understand asset allocation is to consider it as a financial strategy by diversifying the overall investment into various investment categories like stocks, bonds, fixed deposits, real estate etc. Since each financial instrument carries its own unique risks and reward opportunities, having a balanced asset allocation means covering all bases of high risk and low risk to attain a well balanced and diversified portfolio for investment.
Advantage of Embracing Asset Allocation:
Each asset class works differently and must be selected keeping in view various parameters including risks of the asset class, the timeline of investment and the quantum of returns offered. Investment vehicles like bank fixed deposits and post office investments or government backed bonds come under a low risk investment category offering assured returns after a stipulated time period. The returns may not be substantially higher compared to slightly higher risk investments like shares and mutual funds. Asset allocation must always be diverse and balanced so as to offer a holistic and balanced effect to the investor.
Basic Parameters to Decide on Asset Allocation: Asset allocation is a very personalized thing and is different for each individual. One can efficiently plan his asset allocation by keeping in mind the following factors:
- Age of the investor
- Quantum of amount available / can invest systematically
- Timeline of investment planned by the investor
- Number of dependants
- Overall financial goals
- Financial needs / Financial outlook
An asset allocation which may work for a 25 year old single individual may be entirely different from a 40 year old man with a family which again may be different compared to a 65 year old retired individual. One must never compare asset allocation as each person has a different financial outlook and financial needs. A personalized asset allocation must be built keeping in mind the risk bearing capacity and the individual’s overall financial goals.
Asset allocations are broadly classified as aggressive, balanced and conservative depending on the risks associated with the financial instruments involved in the asset allocation. Let us look at the three distinct types of asset allocations with illustrative examples.
Aggressive Asset allocation: An aggressive asset allocation is one in which the ratio of investment in high risk instruments like equity based instruments is more than 50% of the total investment. Aggressive asset allocation is suggested for the young investors which who usually have a higher risk taking capacity and can rebuild their corpus in case of a market crash considering a worst case scenario.
Illustration: Like in our example, the case of Mohan is ideal for an aggressive asset allocation. Mohan can easily build his asset allocation which can focus 50-60% in equity based instruments like mutual funds, another 20 to 30% in fixed income products or long term debt funds. Since gold is considered to be one of the oldest and safest investment products over the years, allocating 10% asset for gold based ETFs can be considered. Apart from these investments Mohan needs to make sure he opts for an adequate health cover and continues investing in PPF along with effective tax planning.
Balanced Asset allocation: A balanced asset allocation as the name suggests is one which keeps into account the pitfall of each asset allocation and is not a high risk investment. The percentage of investment in high risk equity products is reduced while investment in debt based funds and fixed deposits are increased proportionally. Balanced asset allocation is best suited for individuals between 35 to 45 years of age as they have the responsibility of home, family and dependants along with some possible loan repayment obligation like housing loan or car loan.
Conservative Asset allocation: A conservative asset allocation is the least risk taking asset allocation module focusing on assured returns rather than high and risky returns. Conservative asset allocation focuses more on government bonds, fixed deposits and debt based funds which offer an assured money back guarantee within a stipulated timeline. Conservative asset allocation is ideal for older investors who are seeking better returns than saving banks accounts with the same surety of returns and high liquidity in case of any immediate financial need.