Congratulations, so you’ve decided to invest your money instead of letting it sit idle in a savings bank account 😎
Now that the first step is out of the way, you have to decide where and how you wish to invest your money. In other words, you have to allocate your assets among various investment classes, such as equity (stocks, equity mutual funds), debt (cash, term deposits, liquid funds), real estate, commodities, gold, ETFs and Index Funds, art and so on.
Understanding Asset Allocation
Asset allocation means striking the right balance between risk and reward by adjusting the investments in your portfolio depending on your risk appetite and time-frame, based on your financial goals. Here are some pointers to get your asset allocation right.
1. Thoroughly understand your risk appetite
The most important component of your asset allocation strategy and will determine how and where you choose to invest..
First off, how much loss is ok?
Ideally, the answer would be zero, but suppose that isn’t the case, how much of a hit can you take without batting an eyelid? 🙂
While this is a rather subjective question, it will depend on
– your age: the older you get, the more you’re likely to want safety/assured returns
– your experience: if investing since long, you are armed with “better” knowledge about investment cycles and potential risks
– disposable income: obviously the more money available to invest, the more liberal you are likely to be with your investing experiments
Every form of investing has some degree of risk in varying levels, such as
– inflation risk: rise in costs, which can eventually lower your effective returns
– market risk: market crash leading to fall in price of your investments & wiping out your holdings
– risk of default: failure of the entity you invest in, whether a company, bank or even a Govt
Risk itself can be further classified as your risk capacity – your ability to take a risk, or your risk tolerance – your willingness or attitude towards risk.
2. Investment horizon – Long-term, medium-term or short-term?
When do you want your money back? If there was ever a balancing act, this is one!
This time horizon can be spread across months or years, or even weeks, in case of very short-term requirements. If you want your money back soon, you wouldn’t want to invest in a risky option because if the prices fall, you have no choice but to sell at a loss, so you have to look at options with lower returns but better liquidity.
If you have a longer time horizon, it is very likely that you can weather the storms of economic cycles and market rises/crashes by investing in slightly riskier investments with better returns.
3. Set clear goals (short-term, medium-term, long-term)
– While definitions can vary, a short-term goal can be less than/within a year – like a family vacation or a solo trip abroad, attending some music/sports event, buying a gadget/appliance etc.
– A medium-term goal can be one in the 3-5 year range, such as marriage, buying a house, starting a family and so on.
– Long-term goals can include kids’ higher education, their marriage, your retirement.
In each case, having a clear goal and then working backwards will make it easier to decide your asset allocation and if those investments can help achieve your goals.
If you’re looking to get married or start a family, you may prefer investing in assets where safety is more important rather than returns, whereas if you’re building a corpus to fund your kids’ education, which is several years away, adding some risk in the form of equity will give it the much needed boost to meet your goals.
4. Build a portfolio (different ones for different goals if needed)
Your appetite for risk would broadly define you as an aggressive, conservative or passive investor and determine the type of assets you invest in that make up your portfolio.
Different asset classes perform differently over periods of time. The key to ensuring your portfolio stays stable is by diversifying across asset classes based on the above mentioned risk appetite, time horizon and your goals. You can even create a different portfolio for each of your goals if you wish to, although you would need to spend more time in tracking multiple portfolios.
There are different types of portfolio models that are used, like Strategic Asset Allocation, Dynamic Asset Allocation, Tactical Asset Allocation, Risk & Time Matrix Asset Allocation etc which we shall cover in a later post.
5. Monitor investments regularly, re-balance as needed
One of the key things to remember is – there is no “fill it, shut it, forget it” kind of approach when it comes to investing. You have to monitor and tweak the asset allocation mix on an ongoing basis and manage your budget – based on changes in your income, investment horizon, the economy, or even a change in your goal itself.
Re-balancing means bringing your portfolio back to your original asset allocation mix so any asset class does not have a larger share than intended. Once you’ve decided on your portfolio, checking on it once every 6 months to a year is usually enough.
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