Recently, I received an email from one of my ex colleagues, who reads my blogs, that I might be perceived as a big proponent of Equity and whether it is prudent for all sections of people to bet on equity, especially those nearing retirement and those who have retired.
My response to him was,
“Equity returns cannot be matched by any other asset class and this has been proven world over. But, the % allocation to equity depends on the investor profile. It will be more for young and aggressive investors and low for people nearing retirement/retired. It can be even nil if an investor has sufficient amount of networth/corpus (very few lucky ones!) and he/she can afford not to invest in risky assets.”
This triggered me to blog on a very important concept in personal finance, “Asset Allocation”.
Asset Allocation in simple terms means “Don’t put all your Eggs in One Basket”. In my experience, for a significant proportion of investors, the preferred and largest basket seem to be “Real Estate” which might not be optimal
I am sure people would agree that Sachin Tendulkar is one of the best batsmen that the cricketing world has seen. Does that mean that Indian Cricket team can have 11 Sachin Tendulkars? What about pacers, spinners, wicket keeping?
Proteins and Vitamins are good for health. But can we just consume Proteins and Vitamins alone? How would we get the energy without consuming Carbohydrates?
Similarly, to get optimal returns from investments we need:
- Allocation to various assets like Equity, Real Estate, Gold, Fixed Deposits etc. depending on the Investor profile – Diversification across Asset Classes
- Diversification within an Asset Class. For ex. If we decide to invest in Mutual Funds, it is preferable to invest across schemes and fund houses
- Portfolio Rebalancing – Maintain a specific % of allocation to various assets and when one/some of the assets grow considerably, sell some of it and move it to other assets that haven’t done well to ensure the % allocation remains that same, periodically. This is one of the most difficult things to do as selling assets that perform well and investing in other assets that have relatively underperformed cannot be digested easily. But research has proven that this is the best approach to get optimal returns in the long run.
Please remember that there is a difference between “Best Returns” and “Optimal Returns” as highest returns means taking very high risk, which is not what is recommended. Also, when diversification is done it should not be done for the sake of it but with a purpose. For ex. diversifying the portfolio with asset classes having negative correlation (when one goes up the other goes down) like Gold and Debt helps generate optimal portfolio returns.
The following illustration can help understand asset allocation better.
RAM and SAM are 2 friends living in Chennai, both having Networth of Rs. 1 Crore as on 1st Jan 2014. Both of them have invested in property (Land), Gold, Bank Fixed Deposits and Large Cap Mutual Funds but in different proportions. The property prices have been stagnant during this year and there has been no appreciation. Gold has given a negative return of -7.4%, Bank FDs have returned about 9% and Large Cap MFs have given 35%.
|Large Cap MFs
|Value on 1/1/14
|Value on 31/12/14
|Value on 1/1/14
|Value on 31/12/14
Please note that while both have invested in the same asset classes, their returns at the end of the year (SAM has earned a return of 15.9% while RAM has earned only 9.4% resulting in a networth difference of 6.52 Lakhs at the end of the year) are different due to the difference in % allocation and especially due to the tremendous returns from Large Cap Mutual Funds
Each asset class has a specific objective and behaviour, (Real Estate tends to do well when interest rates are low (capital appreciation) and inflation is high (Rental yields increase), Equities tends to do well when the economy is on the growth path like the current scenario, Gold tends to do well during periods of uncertainty like the crisis in 2008/9) and constructing a portfolio with right assets and allocation, suitable to the investors profile is the key to earning optimal returns.
Wish you a very happy and prosperous New Year 2015 and hope 2015 creates substantial wealth for all of us!
<Blog # PenguWIN 1020 – All About Asset Allocation>