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.
The
content made available in this article is for general informational purposes
only. While every effort has been made to ensure the accuracy and completeness
of the content, it should not be considered as a substitute for professional
consultation.
