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Thursday, November 18, 2010

About Asset Allocation – a guest post

Many small investors jump into the market – usually near bull market peaks – without doing any prior homework about how the stock market or mutual funds industry operates. They end up with a portfolio full of questionable investments that teaches them a very costly lesson – there are no short cuts in life, and definitely not in the field of investments.

Now that the stock market is hovering near its all-time peak, Nishit’s guest post addresses the important concept of asset allocation. Investing without an asset allocation plan is like going to a railway station and hopping on to the first train that is leaving a platform without knowing where it is headed. You may get somewhere, but it may not be a place you want to visit.

The thrill of adventure of not knowing where you are going – physically or financially – may be fun for a while, but expensive in the long run. Following an asset allocation plan takes away most of the uncertainty of your investment future, and ensures that you stay invested through the ups and downs of the market.

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Today, we explore an important pillar of financial investing: asset allocation. Before we move further, let me ask you one of the most fundamental questions: Why do we work for a living? Why do we spend stressful hours commuting, tolerating unpleasant bosses, enduring long caffeine-fuelled meetings? Do we do it because we like doing it? Some of us may love our work greatly, but for most it is a way of earning money. The path to an early retirement is proper asset allocation.

Assets are of various types. They could be equity, debt, real estate, gold, and cash. The idea is to earn an optimum rate of return by taking the right amount of risk. The risk profile of every person is different. Riskier assets generally yield more returns, but not everyone can take the same amount of risk. A person aged 30, having a good job can withstand some capital erosion but a retiree at 65 with no avenues of earning money other than those generated from his assets can’t afford to lose money.

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A thumb rule of asset allocation is that a person can invest upto (100 - age)% in equity. For example, a 30 year old can have 70% asset allocation to equity while a person who is 65 years old should avoid investing more than (100 - 65 =) 35% in equity. Now, thumb rules are meant to be only a guideline.

While making an asset allocation plan, one must also look at the ease of liquidation of the assets. How many days would it take to liquidate the assets and have hard cash in hand? Equities and gold ETFs normally take 3 days from the date of selling to get cash in hand. Debt can usually be redeemed in about a week’s time, be it mutual funds or fixed deposits – sometimes with a penalty of 1-2%.

The trickiest asset is real estate. It requires legal documentation, involves part transaction in ‘black’ money and has almost no transparency. Also, when the prices start falling you may find no buyers. I am a strong advocate of the policy of owning only the house you live in. Else, invest in REITs or stocks of real estate companies.

The trick is to treat all your assets as a fund and find out what the rate of return on the portfolio is. Any return above 16% (twice the 10 year government bond rate) is an excellent return on investment. The idea is to get rich slowly, step by step.

The cardinal rule to be followed is preservation of capital, followed by return on investment. For a 30 year old, the portfolio could be 20% gold, 40% equity and 40% fixed income. For a 60 year old the equity could be 20%, rest in gold and debt.

An example of retiring early and doing what one wants is Lakshmi Ramchandran, who blogs at http://vipreetinvestments.blogspot.com/. She took Voluntary Retirement from her bank in 2001 and is doing what she loves most. She does Technical Analysis, trades the market and enjoys life at her own pace.

Further insights on asset allocation can be found here: http://www.investopedia.com/articles/pf/05/061505.asp

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

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4 comments:

Lakshmi Ramachandran said...

Thanks Nishit, I didnt know I could be quoted

Titu said...

Hello Sir,

In Intelligent Investor Graham said "fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks" he never said anything about age.
You can read its elaboration in 'commentary on chapter 4'

Also I think your gold allocation is little high at 20%, but it's good for liquidity purpose.

I like your view on real estate, I even not advocate investing in REITs just b'cos they are not well Regulated and transparent.

If I am wrong some where, please guide me…

-titu.

Nishit Vadhavkar said...

Thanks Titu. Again it is a matter of perception and risk appetite. 20 or 25% does not make a huge difference. Ben Graham's words are meant to be a reference point, not the holy grail. Gold high weightage is due to uncertain times we live in.

K S Selvakumar said...

I was always uneasy about the real estate sector. Your view kind of validates my fear. Nice write-up. Thanks.