3 questions to ask before doing asset allocation

How do you do asset allocation for your investments – is the question which probably even half-serious investor starts the investment journey.

And why not?

There are n number of ways you can allocate your funds for investments. And this makes the investor spoilt for choices.

So, how do you go about asset allocation?

Like many other questions about investing, there is no fixed answer to this. Rather, there can be multiple right answers. Different people can have different asset allocation strategies. And all these can be right at the same time.

You need to choose the asset allocation strategy that best suits your needs. This holds true whether you have few thousands or few millions!

What are the different asset classes you can invest in?

How should you do asset allocation?

While there are lot of possibilities, here are some major asset classes that are available

  • Equities (including equity mutual funds) – Typically equities have performed well over long time horizon. However, returns are not guaranteed. But for a growing economy, the returns are expected to be good.
  • Debt (fixed deposits, PF, PPF, bonds, debt funds, liquid funds etc.) – In long run, they have usually given lesser returns than equities. But they are typically more predicable in nature & hence less risky.
  • Real Estate (land, house, commercial properties etc.) – If not used for residence, they can provide a rental income or capital appreciation (not guaranteed). However, they are quite illiquid in nature.
  • Gold (and other precious metals) or their ETF (Exchange Traded Funds) – Usually considered to be a hedge against inflation and market volatility. It is also something that is considered to be have a high emotional value among many people.

In addition, there may be other asset classes available, but will not delve into it as they may not be so mainstream and I lack understanding of them, or both! (Also, insurance is NOT investment, in case you are thinking on those lines.)

There might be some products that offer a mix of multiple asset classes (usually debt & equity). However, most of them can be broken down into above categories.

How do you arrive at an ideal asset allocation strategy?

I will, as usual, refrain from giving answer, since there is no one size fits all solution. but would share some factors that you should consider.

Here are 3 major factors one should consider while doing asset allocation

1. What are your investment objectives?

One of the primary questions to ask is – are you looking for capital protection or capital appreciation?

If you are looking for capital protection, then debt instruments maybe best suited for you.

Typically, returns on debt instruments have been in line with inflation (marginally higher) while that in equity have beaten inflation over a long term. (unless your lifestyle inflation is high)

If you are looking for capital appreciation (but OK with some risk), then equities may be best suited for you. If you don’t have time, energy or capability to research on individual stocks, you should opt for mutual funds (preferably via SIP route)

In addition, age is also a factor that you should consider. If you are closer to retirement, then you may be better off chasing capital protection than capital growth or locking liquidity in an illiquid real estate.

An ideal portfolio mix would have both debt & equity. But will this mix be 80 percent debt : 20 percent equity or vice versa (or any ratio, which you are comfortable with!) should ideally depend upon your investment objective.

2. What are your liquidity requirements?

Do you need the invested money now or in next couple of years or do your need money after a long term time horizon (decade or money)?

Typically, longer your investment horizon (in terms of when you need more), more you should opt for equity.

For immediate need and for contingency fund to account for any unforeseen emergency, you should ideally have it in a debt instrument. You also need to consider the lock-in period. For instance, you should not be parking your contingency fund in PF (Provident Fund) or PPF (Public provident fund) which have lock-in periods!

3. How is your temperament?

You may be very optimistic about and heavily invested in equities, but what is the point if you lose sleep over even minor fluctuations (like stocks tanking 2% in day!)? Or you keep on worrying about your tenants and their tantrums? Or if your blood pressure rises if you hear about any happening around the world which can potentially reduce your net worth?

Whatever, asset allocation you chose, it need not unduly affect your piece of mind or health unnecessarily.

So, if you fret over value of your mutual funds daily, or most of your net worth is tied to a real estate property which you are unable to sell at the “right” price, you may be better off with other asset classes (maybe, with lower returns) than the high returns but low peace of mind investments.

Few more things to ensure before approaching asset allocation.

  • You are debt free (or maybe, have housing loan for your primary residence as your only loan/ EMI, unless you are an investing genius!)
  • You are sufficiently insured – At least term life (if you have dependents) and health insurance.

Failure to meet any of these assumptions may expose you to some risk even if your asset allocation is perfect.

To sum up …

Asset allocation is the first step towards having a sound investment strategy. While your approach may undergo many iterations as you progress in your journey, a right thought process and a right approach can be a good starting point.

Have anything else in mind?

Do share.


7 thoughts on “3 questions to ask before doing asset allocation

  1. That’s a really good shout out about thinking about how your temperament is. I’ve been toying with the idea of getting a buy to let at some point. The trouble is, every time I think about it I start to feel stressed. Probably a good sign that my temperament is better suited to slightly less hands on investments.

    1. True. We need to choose what best fits our needs & temperament …

      Thanks for dropping by & sharing your thoughts.

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