Asset allocation, asset classes, risk appetite and diversification are concepts that all go hand in hand. Unfortunately, these concepts often go above our heads as well. Here’s one way to look at it – just as nutrition is to a healthy body, so is asset allocation to your finances. What would happen if you didn’t have a balanced diet?
Masala Dosa! Aloo paratha! Pizza! Burgers! We all know somebody whose face lights up on hearing at least one of those words. Does your face light up too? But what if you ate only one of these four items for breakfast, lunch and dinner, all year round? That’s 1,095 servings of just one food item. Not only would your face fall after a few days, but your body would also revolt.
A good mix of different kinds of foods is necessary to give us the protein, carbohydrates, fats, vitamins, and minerals that we need. Your finances, too, need a healthy combination of assets to stay in good shape. Investing your money in more than one asset class based on the principles of asset allocation lowers the risk of an unwieldy portfolio.
Let’s begin by knowing our asset classes
Speaking of asset classes, the five major classes are equity, fixed income (eg: debt mutual funds, fixed deposits), real estate, commodities (like gold and silver), and cash. The newest asset class on the block is cryptocurrency, while art and fine wines constitute the collectibles category.
Determining Your Asset Allocation Strategy
1. How age plays a role
To begin with, using a rough thumb rule like “100 minus your age” works quite well. What this means is that the percentage of your portfolio that you invest in fixed income instruments, like debt mutual funds and fixed deposits, should be equal to your age. Whereas the percentage that goes towards equity should be 100 minus your age. The reason behind this is simple.
Let’s say you’re 25 years old and you invest a major chunk of your money in high-risk equity instruments. A year later, this investment fails miserably. Because you are young, you have the luxury of time to build up your investment portfolio from scratch.
Now suppose this investment does consistently well. Once again, you have time on your side to ride out the risk and see the returns through. The younger we are, the more benefits we reap from compounding.
2. Figuring out your risk appetite
Think of this as spice tolerance. Not all of us have taste buds that are equipped to handle the bhut jholakia, aka the ghost pepper, one of the hottest chillies known to humans. And if we do, it’s in an extremely small quantity, its fire subdued by a variety of other ingredients.
For somebody who’s a tad sceptical about cryptocurrency, I wouldn’t invest all of my money in it, only the amount that I have the capacity and the tolerance to risk.
My risk capacity simply indicates how much I can invest towards a certain avenue considering my income, how many people depend on this income and the liabilities that I may have. My risk tolerance indicates how I deal with fluctuations in the market. If volatility gets me nervous easily, I would steer clear of high-risk investments such as cryptocurrency. And if I do invest in it, I would only put in a small amount, an amount I’m okay never seeing again.
Just like everyone’s taste buds are different, risk appetite varies for everyone.
3. The impact of your financial goals
Another thing that varies for us all are our financial goals, and the time horizon we set to achieve these goals. The closer you are to your goal, the more should be invested in low-risk investments, and vice versa.
A long-term goal like building a retirement fund would require a mix of assets that leans toward the equity side. Picking the appropriate investment avenues for your portfolio becomes a lot easier using this rationale. (Refer to What Nobody Tells You About Goal-Setting).
Diversification
Consider asset allocation as step 1 and diversification as step 2. Step 1 ensures you’re investing in different asset classes; Step 2 ensures that you further spread those investments within each asset class. Both steps are required for a truly diversified portfolio.
Think protein sources. Are lentils the only source? For vegetarians and non-vegetarians alike, we all try to add a few more sources to the mix. Be it with nuts, dairy, soy, eggs, fish, meat or more.
Similarly, let’s say you’ve decided to allocate 25% of your portfolio to fixed income instruments such as FDs and debt mutual funds. But you invest the entire 25% only in fixed deposits of a particular bank. If the bank collapses, your money is stuck, or worse, wiped out. To avoid this risk, it is necessary to diversify your investments within each asset class. In this example, splitting the 25% in both FDs and debt mutual funds would be wise.
Another example that comes to mind are equity mutual funds. Rather than investing directly in shares of a handful of companies, equity mutual funds ensure your money is diversified to a greater extent. It is safer to invest in 20 companies via a mutual fund rather than investing directly in only 2 companies.
Selecting a good mix of investment products, like in the image below, safeguards your portfolio, making it robust and well diversified.
The Bottom Line
The classic phrase, “Don’t put all your eggs in one basket”, is the perfect encapsulation of what asset allocation means – a simplified way to build an investment portfolio that minimizes risks and generates substantial returns. It’s also a good practice to review these baskets periodically, say, every year, based on your current situation. Giving your finances a regular check-up, just as you would for your physical health, guarantees longevity.
Remember, when you eat right (and have an active lifestyle), the calories take care of themselves. So also, when you invest right (and manage your expenses and debts well), the returns do the same. You needn’t overthink it.
P.S: This week’s book recommendation is a comprehensive personal finance guide, Let’s Talk Money, written by financial journalist and Certified Financial Planner, Monika Halan. A must-read to learn how to make your money work for you.
