Classes of Assets, Asset Allocation & Importance of Asset Allocation

An eight month old baby, a growing child, a middle aged worker & a seventy year old person would all define their ideal diet in different ways. A diet suitable to a growing child could bring indigestion to an eight month old baby, similarly a diet of an old person would not give sufficient nutrition to a middle aged worker. If such a basic part of one’s living, diet, is different for different persons to suit the physical health of that person, so is the investment strategy (how an investor’s portfolio is invested across different asset classes) for different types of people to suit the financial health of that person.

In this context we have a look at what different asset classes are, what asset allocation is & what is the importance of having a proper asset allocation.

 

 

 

Asset Classes & their characteristics

Common asset classes that form part of an average investor’s portfolio consist of Equity, Debt, Real Estate & Gold.

 

Equity refers to ownership. Returns from investment in equity depends on the profitability of an enterprise. And profitability of an enterprise cannot be predicted. However successful enterprises make good profits over a longer period of time. So an investment in equity would have too much volatility in the short run, but robust return in the long run. Hence an investment in equity is ideal for beating inflation in the long run. Common examples are equity shares, equity mutual funds and the more esoteric equity PMS, foreign equity holdings and variations thereof.

 

 

Debt refers to what one lends to another. Return from investment in debt has no connection with the profitability of an enterprise. An enterprise normally uses borrowing as a substitute to owner’s equity. A person who lends this amount gets fixed interest on the amount so lent. Thus an investment in debt would fetch one a fixed return at periodical intervals. It is therefore ideal for a person who requires fixed income or whose goals are short term where he can not afford to have the uncertainty  of return from equity. Thus a debt investment is ideal in the short run to take care of short term and medium term goals but not suitable to beat inflation in the long run This could be either in Government or private sectors. Common examples are Bank FDs, Corporate Deposits, Debentures, Post Office Savings, Provident Fund, Bond Funds, etc.

 

 

Real Estate refers to an investment in land or property. An apartment used for residing or a shop or office purchased for conducting business should not be categorised as an Asset, unless the person plans to sell it. A real estate is any property purchased with the intention of letting out on rent or selling at profit at a later date. However in case of an emergency requirement one can not sell a portion of one’s house. An investment in a physical real estate therefore has liquidity issues.  Common examples are second house, plot, shop purchased by a salaried person, the more recent types being REITs, etc.

 

 

Gold is man’s oldest and most reliable asset. It could be termed as the most liquid of assets next only to currency. However in case of investment in Gold, people tend to become emotionally attached. Return from this asset class is only when you liquidate it. It is not suitable for a person who requires periodic return. At a basic level gold could mean either gold jewellery, gold coins or gold biscuits. For a mature investor this could be gold bonds or gold ETF.

 

 

Asset Allocation

Asset Allocation refers to parking one’s total net worth in a sensible mix of assets. This mix of assets  normally consist of all the asset classes, but in different proportions depending on the investor’s background. For an asset allocation to be sensible it is important to consider several factors of which the investor’s age &  risk profile are the primary ones.

Importance of Asset Allocation

An investor’s portfolio requires proper asset allocation to ensure a right mix of growth, stability, liquidity. However these components namely growth, stability & liquidity would vary depending on the investor’s background.

This allocation is comparable with the diet of people from different age groups as we saw in the opening para of this article. 

 

 

A youngster having a regular source of income from salary or business & one who has several years remaining for his retirement should ideally have a major component invested in equity so that he gets the benefit of higher returns over a longer period though more volatile. A middle aged person who may be having kids with education expenses should have a suitable amount in readily available investment vehicles (debt). If this person has a good period of time remaining  for his retirement he should invest a portion of his net worth in equity to take the benefit of higher returns. A retired person should have a major portion in debt to ensure that he gets fixed but regular returns.

 

Sometime investors, irrespective of their age &/or risk profile, feel they are better off with one or two asset classes in their portfolio. This is mainly due to the comfort factor they feel with a particular asset class. An important reason why they may prefer to remain away from an asset class is perhaps they may not understand the same properly or may have had an unpleasant experience in investing in the same.

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