PPF DIARIES: CHAPTER 4: ASSET ALLOCATION
Dear Reader, If you are reading this, it would be prudent for you to read the previous chapters of this PPF series. That will make this reading more meaningful.
Chapter 3: Risk Profiling: https://ppfbypathikvariya.blogspot.com/2020/06/ppf-diaries-chapter-3-risk-profiling.html
Once you have read all of the above chapters, it means, you are now ready to invest! You have created the emergency fund and got enough insurance. You also know how much risk you can afford to take. The next step in the personal finance journey is to work on asset allocation. We all know about the proverb that says not to put all our eggs in one basket. That reduces the risk of losing all the eggs if the basket is lost. But it does not tell us about how many (different types of) baskets should be there, how many eggs should I put in those different baskets, and finally, how to decide how many eggs should I put in each basket?! Sounds confusing?! If the answer is yes, you need to reread the above text! If no, you are with me! Let us explore the idea of asset allocation as practically as possible. To understand the idea of asset allocation, the first thing we need to do is to understand a few terms. Let us explore a few terms first.
1. Asset: An asset is something useful you hold. Something precious. Without much beating around the bush, let us understand it from the perspective of personal finance. It is anything that you own - a house, money in your bank account, FDs, gold, equity shares etc. Some assets are tangible while some are intangible. For example, a house is a typical tangible asset, while equity shares are a typical example of a non-tangible asset. These assets are the core part of your financial journey. Assets help you create wealth. They have the power to make you wealthy (or poor, depends). They can secure your life goals like buying a house, buying that car, a foreign trip, education of children and so on. It is the mix of these assets, with reference to your risk profile (as discussed in chapter 3 of this blog), that is the key to be able to achieve the financial goals in the long run. This paragraph was based on the following link's text (All the credit to its author): https://www.nerdwallet.com/article/finance/what-are-my-assets
2. Liability: Investopedia says, "Liabilities. Liabilities are merely what you owe. Liabilities include current bills, payments still owed on some assets like cars and houses, credit card balances, and other loans.(https://www.investopedia.com/articles/pf/08/evaluate-personal-financial-statement.asp#:~:text=values%20as%20well.-,Liabilities,card%20balances%2C%20and%20other%20loans.). Generally these liabilities are viewed as roadblocks to achieving your financial goals. They typically come in the form of monthly Easy Monthly Installments (EMIs). It is another thing that how 'easy' these installments are, is a matter of discussion and debate. The current lifestyle demands are such that we have to take various types of loans including housing loans, personal loans, gold loans, and so on. Basically, such loans should be avoided as long as possible. Because these liabilities directly reduce your ability to create wealth. Yes, some financial experts opine that housing loans can be handy (and are believed to be an exception in this regard) as they help you save taxes and create wealth at the same time.There is something called Rule of 40/100 EMI/income EMIs make a major dent on your monthly budget, therefore, it is advisable that it should not exceed 40 percent of your salary.(https://www.deal4loans.com/loans/articles/what-is-ideal-emi-to-income/#:~:text=Rule%20of%2040%2F100%20EMI,per%20cent%20of%20your%20salary.) But I personally think that EMIs should never be more than what you can psychologically and financially manage. There are some liabilities, that should be dealt with very strategically like the Credit Card dues.
Plus, loans should generally not taken on depreciating assets like cars, mobile phones, and foreign tours! Only a housing loan is justified as it helps you create a genuine asset.
3. Asset Allocation: Here how Wikipedia defines this term, "Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor's risk tolerance, goals and investment time frame.[1] The focus is on the characteristics of the overall portfolio. Such a strategy contrasts with an approach that focuses on individual assets." (https://en.wikipedia.org/wiki/Asset_allocation#:~:text=Asset%20allocation%20is%20the%20implementation,goals%20and%20investment%20time%20frame.)
Now, to understand the idea of asset allocation, you must understand that every type of asset performs differently in different markets. For example, 2014-17 were the years, when equity outperformed every other asset class. But, of late, gold and silver have had a wonderful run. 2008-11 was the golden period of the real estate.
So, what does it all mean to a retail investor? The retail investor must understand, that s/he must invest in types of assets, which provide diversification (do not put all your eggs in one basket). For example, if I only invest in stocks, I may be rewarded when the share market is booming, but what about my investment, when the markets are economy are struggling. In the same way, if I keep investing in gold, it may do well when equity and other asset classes perform badly, but its historical return has not been good enough to beat the inflation by a wide margin. Generally, gold is a way to hedge against the risks that come with investing in equity. It is because when equity performs, the gold remains stable. But when the equity fails to perform (something that has been happening for the last 1.5 years), the gold will shine. In short, both have an inverse relationship in terms of providing returns.
So thus, in short, asset allocation, is nothing, but a decision to invest in different asset classes, based on the risk tolerance profile. If you invest 80% in equity and the market fails to generate returns for a long time, it may lead to stress. So, asset allocation is highly relative- it is supposed to be customized for every individual.
Now, you may ask, how the hell do I achieve this (optimum) asset allocation (that is made for me based on my risk tolerance ability)? Here are a few practical tips that will help you with achieving the same:
1. Do not invest in any asset class that you do not understand: Warren Buffet could avoid a lot of losses in the 1990s as he kept away from the .com bubble. The same goes for assets like crypto-currency (for example, bitcoins). It is also believed that retail investors should not invest in real estate as the real estate market is quite complex to understand, it requires too much investment and it cannot be (easily and urgently) liquidated in case of emergencies like equity shares or bonds.
2. Always strike a balance: Everyone wants to buy Reliance shares now. Everyone wants to invest in Pharma funds now. Everyone wanted to invest in gold one month back. It is a normal tendency to chase a well-performing asset class. But every asset performs in cycles. And not all asset classes will go up or down together. So, if you diversify and invest in more than one asset class, your average returns will not see much fluctuation and you can still beat the inflation as well. Do not chase any single asset class that is going to be disastrous for your wealth creation journey.
3. Invest systematically: Asset classes like equity are highly volatile. And you all may be aware of the concept of rupee cost averaging. So, go for SIP types of method of investment, which allows you to invest a fixed amount at a regular interval. That will allow you to save yourself from the worry of "timing the market" and you can invest more (gain more units) when the markets are down and invest less (gain fewer units) when markets are up. This will boil down to the rupee cost averaging in the long run and it has a high probability that you will generate inflation-beating returns if your asset allocation was ok.
4. Hire the services of a financial advisor: There are many financial advisors, who are registered with SEBI. They are not distributors or brokers of any company of Mutual Fund or Finance. They charge fees based on impartial considerations as they will not make money out of commission from any company-their source of revenue is the fees of the clients. We are not habituated to pay fees for professional advice in India. But then, there is no free lunch. We goto physicians and lawyers and pay fees for their specialized services. In the same way, we must pay fees to the qualified and SEBI registered financial advisors. They will do your risk profiling, asset allocation, and goal-based investing process scientifically.
Conclusion: All in all, there are two success mantras to achieve your financial goals (there are many, but based on our discussion, two are): 1. Right asset allocation based on risk tolerance profile 2. Systematic investing to deal with volatility. (I will write a dedicated post on systematic investing).
FINAL TAKE AWAY: This asset allocation is not 'fixed'. You have to change it with your age, the achievement of goals, changing needs, etc. And your financial advisor will always stand by you in achieving this asset allocation. Please pay the 'fees'! without hesitation. If he charges 0.01% of the returns that he helps you generate (roughly speaking, as such, every financial advisor charges based on her qualification, experience, and expertise only and not based on your assets under management), this 0.01 % fee, in fact, is a good investment only!
