By Uma Shashikant
“When I tell investors that asset allocation is the most significant decision they make about their wealth, there is disbelief. Across groups, from the wealthy, who do not look beyond property, to the middle class, which is obsessed with gold, asset allocation seems like a bit of theory. However, the truth is that asset allocation impacts your wealth the most, at all times.
The stock you buy would not matter if you did not have enough money in equity to begin with. Investors make allocation decisions mostly by default, without thinking about it as a strategy about their wealth. We know of young investors who buy property, goaded into believing that they are building an asset and that the EMI is a compulsory saving. Then there are retired investors, who refuse to look beyond fixed income products and deposits, to ensure safety and steady return. There are entrepreneurs, who invest all their wealth in their businesses, confident about the control they have over their assets. Several hold large amounts of cash in their savings accounts since they have not made up their minds. All these are situations where the focus is on asset, not allocation.
Why are these decisions harmful? A sensible asset allocation decision aligns the assets to the investor’s needs. It is strategic as it looks into the foreseeable future and builds the allocation bearing the risk, return and liquidity needs in mind. A young investor confident about the future thinks of property funded with EMI as a good option. What he may have missed are liquidity needs and divisibility. If a portion of his assets is needed for funding a large expense, his asset allocation, which is skewed in favour of property, does not let him liquidate a few rooms, doors and windows to fund it. A retired investor seeking the safety and steadiness of a bank deposit may miss the risk of inflation completely.
A fixed rupee return will become less valuable over time. The allocation should include some investment in a growth asset, even if risky in the short run, to ensure protection against inflation. An entrepreneur, who reinvests all his money in his own business, exposes his family to the risk of concentration of assets in a single venture. Any failure will impact his household, and he needs asset allocation to buffer his family from such risk. The investor who holds cash has allocated a sizeable portion in an asset that provides minimal return.
Cash is a parking space before it is invested in an asset. Too much cash can bring down the overall return. In all the above examples, investors have made asset allocation decisions, but they are not considering their own needs in terms of return, risk and liquidity. They have not made these decisions with strategic intent, but with the simplistic notion that building any kind of asset is good for them. In asset allocation, three things matter most. Why do you need the asset? How much should you hold? And for how long? The answers to these questions have risk and return built into them. If a retired person is investing in deposits and needs steady income, he should ask if the returns are adequate. If the answer is no, since inflation will increase the need for income as years go by, the allocation to deposits should not be 100%.
If the investor is considering equity as a good option since it will help the money grow, he will need to do so for 10-15 years to gain from it. As a retired investor he may not be willing to risk too much in a volatile asset like equity, so the allocation has to be limited to provide growth and contain risk. An allocation that puts away 30-40% in equity, the rest in debt, and retains this proportion over 10-15 years, should work. The retired investor can reallocate the accumulated corpus to deposits after 15 years to augment income. If he sees himself working for another 5-10 years and, therefore, needing lesser income from his investments, he can consider a higher proportion in equity. This is only an indicative discussion, but reveals how the decision about assets and allocation is driven by the investor’s requirement from the asset and the period after which he needs the money.”
Uma Shashikant, from the Center for Investment Education and Learning, breaks down why asset allocation is so important and that you might actually be asset allocating without knowing it. Are you sitting on a pile of cash wondering when to enter the market or are you heavily invested in one asset class or your business?
Let me know what you think.
Per Olov Jansson
CEO Cardea International