Asset allocation and Diversification

Sound money management requires both asset allocation and diversification. Keeping your wealth stored in a sensible and diversified mix of assets is the key to avoiding catastrophic losses.

Investors often conflate these two terms --for example, they assume that if they have an asset allocation plan in place, it will lead to automatic diversification. Conversely, by diversifying across the board, they assume their asset allocation is also in place. Both could be a far cry from reality.

Here are three aspects of asset allocation you must be aware of.

1) Asset allocation is not diversification.

Investors tend to use the terms 'asset allocation' and 'diversification' interchangeably. They pack their portfolio with a dozen funds and believe they have achieved both.

Asset allocation is the process of determining the right mix of investments you should own. In other words, how much of exposure you need to have to various asset classes. At the most fundamental level, they are equity, debt and cash. It can further be built up by looking at other asset classes such as gold, commodities, real estate, art, private equity, and collectibles.

Whatever your situation or life stage, having the right mix of investments is crucial and can increase returns and reduce risk.

On the other hand, diversification is figuring out how much you must allocate to each asset class. For instance, you may decide on an asset allocation pattern that assigns 65% of your portfolio to equity. This would further entail deciding on the number of equity mutual funds to hold; the mix between growth, value, infrastructure or other sector funds; how many large- and mid-cap funds; as well as whether or not to have an international fund to gain global equity exposure. If you decide to go with just one equity fund, a 65% exposure to a single fund shows no diversification at all, despite the fact that you have planned a sensible asset allocation.

2) You need to make the effort to diversify, after you figure out your asset allocation.

The heavy lifting of any financial plan starts well before individual investment selection. In other words, sensible portfolio construction must commence with asset allocation.

To emphasize the point mentioned above, choosing an asset allocation model won't necessarily diversify your portfolio. Whether or not your portfolio is diversified will depend on how you spread the money within each asset class.

Having said that, the situation may be such that diversification has no place to play. A 24-year old on her first job might have the foresight to plan for retirement but not the financial bandwidth. She may be able to save just Rs 2,000 every month towards her retirement kitty. Her asset allocation would demand a predominantly equity exposure. So she may invest Rs 1,500 every month into a mid-cap fund and set aside Rs 500 to put in her Public Provident Fund account, or PPF. Her asset allocation is in place but diversification has (rightly) taken a backseat.

Summing up, asset allocation maximises the risk-adjusted return and reduces risk by combining asset classes that have less than perfect correlations. Diversification reduces the investment specific risk. Both are necessary to maintain a healthy portfolio.

3) Do not blindly opt for a standard asset allocation plan.

No preset allocation or tool can possibly address the many variables that factor into an appropriate asset-allocation framework.

Take two 47-year-olds who both intend to retire in 10 years. One has limited investment assets and no source of income other than his monthly salary. The other is a wealthy entrepreneur who gets a cash flow from his business, interest and dividends from his investments, and rental income. Naturally, each investment portfolio would be considerably different.

This concept holds true from the standpoint of job stability, as well. A college professor in a reputed institution with a stable job could afford to have a more aggressive asset-allocation mix than someone in a profession with a more volatile income stream.

The volatility in the income stream of a commission-based salesperson or an entrepreneur starting out might call for a larger emergency fund than the typical three to six months' worth of living expenses. The asset mix would also depend on whether or not the spouse has a steady income, how large it is, and if there are other sources of cash flow such as rental income.

One rule of thumb is to use your age as a guide. For instance, if you're 33 years old, put 33% of your portfolio into cash and bonds and the rest into stocks. But like all thumb rules, it has its limitations. Some investors might find that figure conservative. Others might find that it's too aggressive for their particular goal.

For instance, a 23-year old girl who has just got her first job may be saving Rs 2,000 every month for her retirement. In that case, the entire amount can be invested in a diversified equity fund. However, another 23-year old may be focused only on the downpayment for a home within the span of two years. In that case, the money should go into a fixed deposit or a short-term debt fund. This points to another aspect in a similar vein. Asset allocation must take into account specific goals.

Do not blindly follow someone else's asset allocation. It would be wise to sit with a financial adviser to arrive at a customised asset allocation keeping your specific situation and goals in mind.

And finally, your asset allocation strategy is not written in stone. Your portfolio in your 30s could look very different from the same portfolio when you are in your 50s. And as your circumstances change, so must your asset allocation.

 Source: Morningstar


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