Asset allocation, or dividing one’s money into various asset classes, is the best way to achieve one’s financial goals. An investor can balance one’s portfolio by investing in various asset classes wherein some are high on risk with a higher return expectation and some are low on risk and give limited returns. An excellent tool to hedge against the volatility in the capital markets, asset allocation helps investors in overcoming the shifts in the economy.
Asset classes are divided into the following categories:
- Cash: Includes your savings, checking, current deposits, and liquid fund accounts. Usually used for emergency funds.
- Stocks: An investor seeks to earn capital gains by buying a piece of a company. Stocks can be bought using Value Investment Style (Invest in companies with low P/E ratio and which re undervalued) or Growth Investment style ( Invest in companies with above-average returns).
- Bonds: IOUs which signify money raised by a company, municipality, or the federal government by taking debt from the investors. In return, the issuer promises safety of principal, a fixed rate of interest, and specifies the date of maturity.
- Real estate: A high-return, high-risk investment option. Although returns are attractive, liquidity is an issue with real estate investments.
- Gold: A good hedge against inflation.
- Derivatives: Investment options that derive their value from an underlying asset. Are available in the form of futures and options. Asset allocation differs from person to person and there is no standard rule to follow. A risk-loving investor can take on a higher share of investments in equity/ stocks whereas a risk-averse investor should invest more in bonds. Theoretically, one should have the same percentage of one’s portfolio invested in bonds as one’s age.
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Thus, 1 30-year-old person should invest 30% in bonds and a 60-year-old person should invest 60% of his portfolio in bonds (could break it up into 40% in stocks, 40% in bonds, and 20% in cash). However, the percentages vary with each individual’s risk-taking appetite. The concept is that a person’s risk-taking ability decreases with his age and so, should his investments in stocks. An asset allocation plan or portfolio management is like getting a customized suit as per your measurements rather than buying a ready-made suit (mutual fund portfolios). The first step is to find out your own comfort level with the thought of losing money. This can be found out by filling out an investor's profile with a financial planner or some investment websites. On doing this, one has a clear idea about one’s risk tolerance and investment objectives. Asset allocation is not a quick-rich strategy by timing the market. Instead, it is a long term strategy to help an individual achieve his/her financial goals. The general tendency of all investors is that they want whopping returns but are unwilling to lose even a dime. It is because of this tendency that the average investor quits as soon as he sees a slight drop in his investments, thus bailing out at the slightest hint of volatility.
Thus, most of the investors end up entering the markets at the highest point and exiting at the lowest. The common investor, without understanding the fundamentals of various stocks, invests merely on the basis of hearsay and ends up losing money. It is under such circumstances that portfolio management acts as a help. Active portfolio management would not only do a relevant asset class mix in one’s portfolio based on the risk appetite and financial goals, it will also guide an investor about the right time to enter and exit. It also helps in monitoring the portfolio’s performance on a monthly/ quarterly and an annual basis and advises the investor to rebalance his portfolio as he achieves the various milestones in his life. 3. 2 Tax-exempt vs Taxable investments Although the yields on tax-exempt funds are generally less than those of comparable taxable investments, the net income after taxes that they generate is actually higher than the taxable investments for investors in a high tax bracket.
Diversification: Its advantages
Each economic and market condition has a different impact on the equity and debt markets. Unless an individual’s portfolio is well-diversified and has good exposure to both asset classes, it is very difficult to achieve healthy returns. The debt market is more responsive to interest rates and economic conditions whereas the equity markets are impacted by sector/industry-specific news as well as company-specific information. By having a mix of both in a portfolio one can bring down the overall risk considerably and enhance the return potential for achieving long-term results.
Benefit of Compounding
The process of letting your investments grow over time is called compounding. An investor, who consistently invests without withdrawing money, can start earning returns on both his principal as well as his interest due to the power of compounding. If $90 a month are invested in a mutual fundi. e. just $3 a day—an investor could have as much as $18,000 in ten years (assuming an average annualized return of 10%). This is the magic of compounding. Let us take another example: A young boy in his early teens who invests $2,000 a year from age 14-18 would end up with $1,184,600 at age 65. On the other hand, an adult investing $2,000 each and every year for 40 years from age 26 through 65 will be left with only $973,704 at age 65! The difference mainly stems from the fact that the young boy has more time for his money to grow and compound. ________________________________________ Assumes all investments are earning an annual return of 10% and all distributions are reinvested. Automatic investment programs do not guarantee a profit and do not protect against loss in a declining market.
Thus, based on the literature reviewed, the following are some recommendations for investors:
- Portfolio management involves risk management, but it first needs a mental preparation to ascertain the risk-return bargain.
- Always plan for profit: Don’t get bogged down by the thought of losing capital. Once you know what your bottom line is, take the amount of risk that will not leave you in an uncomfortable position even if the worst happens.
- Get rid of investments which are not yielding good returns. Investing is the art of using money to make more money.
- Continuous Review and rebalancing is a must.
- Have a pre-decided budget for investing. Never invest out of your savings or EMIs.
- Re-evaluate your strategies depending on how many milestones have been achieved by you in your life and on your remaining financial goals.
- In case you don’t have enough time, resources and expertise to keep a constant check on your investments, it is better to hand over the responsibility to a professional who, for not too high a fee, will chalk out a fully personalized portfolio for you keeping in mind your risk appetite and will also keep a constant track of the market movements and rebalance your portfolio accordingly.
- Books, articles, and journals Citigroup (2006) Citigroup annual report 2006 [Online]. Available from: http://www.citigroup.com/citigroup/fin/data/ar06c_en.pdf, Goldman Sachs (2008).
- Goldman Sachs Presentation at the Credit Suisse 2008 Financial Services Conference [Online]. Available from: http://www2. goldmansachs. com/our-firm/investors/presentations/current/c-s-presentation. pdf (Accessed: March 2, 2008) Kerwer, Dieter. (2005). ‘
- Rules that Many Use: Standards and Global Regulation’, Governance, 18(3), pp. 453-475, EBSCOhost [Online]. Available from: http://web. EBSCOhost.com.ezproxy.liv.ac.uk/ehost/pdf? vid=4;hid=102;sid=43653db8-e76f-4fe0-ac65 d396ccc2eacf%40sessionmgr104 (Accessed: February 1, 2008) Mayers, D. , Smith, C. W. (1987), “Portfolio Management and the Underinvestment Problem”, The Journal of Risk and Insurance, Vol. 54, No. 1, pp. 45-54. Risk Glossary. (2004).
- Portfolio Management Risks and rewards [Online]. Available from: http://www.riskglossary.com/(Accessed: March 30, 2008) Sloan, Allan; Burke, Doris. (2007).
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