How to prepare portfolio for excellent returns
The following article will help you to build good portfolio with good returns while minimizing risk
What if all your money is invested in only one product or asset class, this can not only restrict returns but also exposes you to higher risk due to lack of diversification. This is where the importance of asset allocation comes into scenario.
The following article will explain the importance of asset allocation and how to do it?
What is asset allocation (investment)?
Simply put, asset allocation is the process of choosing the right mix of asset classes while constructing the portfolio which in turn, can help in reducing the overall risk and enhancing returns.
The principle of asset allocation is doing not place all your eggs in one basket. The intent is to enjoy the benefits of diversification. Diversification helps minimise risk because losses in one type of investment can be counterbalance by gains in others. Essentially, asset allocation is based on the principle that different asset classes perform differently in the given market conditions. For example, stocks provide faster growth and income, but at higher risk, bonds provide stability and lower risk. The importance of diversification also stops from the inability to predict the performance of any asset class for a given time period.
Thus, through asset allocation an investor can diversify his portfolio thereby hedging its performance against risk. This is achieved by investing across asset classes with different levels of risk which helps the investor balance out the overall portfolio risk and optimize the returns.
For example, if an investor has invested Rs 100 in equity and debt in the ratio of 3:2. Assuming that the equity markets decline by 50%, the equity component will theoretically fall by 50% to Rs 30 but the debt component (assuming that it gives a fixed interest of 7%) would be valued at Rs 43. So, the final investment value is Rs 73.
Now suppose if investor invested the entire amount in equity, the investment value would have dropped down significantly to Rs 50. Now consider a real life example, during the fall in markets in 2008, many investors who were largely invested in equities saw their portfolios decline by more than 50%. During the same time there was an asset class which fared significantly better i.e. gold. When the equity markets declined by nearly 52%, it was gold as an asset class which actually delivered positive returns of 25%. Investors who had included gold in their portfolios would have navigated through the downturn far better.
How it works
Before start doing portfolio allocation (investment), an investor should ask the following questions:
1. What is the investment goal means what does one going to achieve with the investment?
2. What is the investment horizon i.e. for how much time can one stay invested?
3. What is the risk tolerance level i.e. how much risk can one take?
For example, an investor who is about to retire and will have no source of income post his retirement would do well to opt for a conservative asset allocation and construct a portfolio that highlights more on regular income with lower risk i.e. invest more in fixed income avenues (like bonds, assured return schemes and cash) rather than equity.
Another Example, consider an investor, who is young, can take on high risk; such an investor can adopt an aggressive asset allocation with higher exposure towards equity and related products.
The Following paragraphs will help you to do asset allocation (build portfolio)
First, it is very important to understand there is no fixed formula for arriving at the perfect asset allocation. The idea behind this exercise is to help build an best asset allocation based on an individual's needs, which need to be assessed on a case-to case basis.
Here are four steps to help in asset allocation.
Step 1: Understand different asset classes
It is important to understand that the underlying intention of asset allocation is to build an investment portfolio with asset classes that are not correlated to each other--if one asset class is losing, the other(s) should ideally gain. Only then, will you be able to diversify the risk of the overall portfolio.
Investors often confuse the concept of asset allocation with mere diversification. For instance, an investor may have diversified his portfolio between stocks and mutual funds. But if he has invested in equity mutual funds, he is still entirely invested in stocks.
Thus, learning about various asset classes and their risk-returns profiles can help you create an optimum asset allocation. Here, we discuss three broad asset classes: equity, debt, and cash and equivalents.
Equity: The most volatile asset class but the one with the potential to provide the most returns over the long term. Equity shares and mutual funds are typical instruments available to investors under this head. If you cannot handle short term market fluctuations and are afraid of putting your capital at stake, it is best for you to have lower exposure to equities.
Debt: Also, referred to as fixed income, it provides more predictable and less risky returns, with the downside that the returns may not be spectacular. The main objective behind investing in debt is to take lower risk (than equities) and earn lower returns. Expectedly, this investment option is suited for an investor, who does not intend to take much risk and an intends to better predict his returns. Fixed deposits, small savings schemes, public provident fund and debt mutual funds are some of the instruments available to investors.
Cash and equivalents: Liquid cash in hand or balance in your savings bank account can be classified under this category. Though the returns from this asset class can be very less (in fact, the least among all asset classes), it has its own importance, especially in times of an emergency, as it is the most liquid of all classes. Some of the options under this asset class are savings bank account, liquid funds and cash.
Besides these, there are also other asset categories like real estate and precious metals, to name a few. Investors should also consider including these asset categories within a portfolio. But as always, before you make any investments, you should understand the risks associated with each of them and make sure the risks are appropriate for you.
Here's an example of how in calendar year 2008, an investor would have benefited by being invested in different asset classes, thereby reducing the impact of a sharp fall in one asset class on the entire portfolio. Investor A was invested only in equities in 2008, while investor B diversified his portfolio across asset classes, with the following result:
Also investors must consider taking assistance from a professional financial advisor who can help them with both, determining the right asset allocation and also build a suitable portfolio. You can write to firstname.lastname@example.org and we provide free guidance.
Points to remember while doing asset allocation
While the importance of asset allocation and constructing a diversified portfolio cannot be loud, investors must not treat it like a one-time activity. In other words, they should not apply strategy like invest and forget it. Quarterly or biannually review and rebalancing of the asset allocation mix is required to ensure that the investor stays on course to achieve the ultimate goal.
An investor must be aware of the tax implications while building the portfolio. For instance before selling an investment, the investor should consider the short-term or long-term capital gain tax liability which may impact the overall returns on the portfolio.
Greed and Fear:
An investor must avoid the greed and fear factor i.e. they should not sell or buy an investment in haste or panic. This may lead to them deviating from the investment objective and even result in loss of capital. Short-term fluctuations should not matter to a long-term investor. Instead, the key should be to focus on the long term, while consistently adopting a disciplined investment approach.
In conclusion, asset allocation has an important role to play in helping investors achieve their investment goals. Hence, the need to pay due attention to it while constructing the portfolio.
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Your Desire to Earn
Once an answer to above questions is available then it becomes easy to decide the asset allocation mix .
Some of the popular investment products available in the market today are listed below:
2. Mutual funds
3. Fixed income instruments
5. Fixed deposits
6. Pension funds
7. Real estate
8. Unit linked insurance plans
9. Global Funds
While an informed investor can create a well designed portfolio for himself, there are products in the mutual funds and insurance segments which offer a new or passive investor the benefit of an inbuilt asset allocation model. As a result, the investor need not go about determining the asset allocation and selecting various investment avenues. These asset allocation products are targeted at investors who neither have the time nor the required knowledge to decide on the ideal asset allocation mix.
Step 2: Who am I?
After having understood the various asset classes and risks associated with them, what follows next is answering a fundamental, yet important question: What is my risk taking level? This, in turn, would determine the exposure towards each of these asset classes.
The answer to this question is derived from your age, income and financial goals/requirements. Being excessively exposed to any particular asset class without understanding one's risk appetite and the risk associated with the asset class can very risky.
Broadly speaking, there are three types of investors depending on the risk profile: aggressive, moderate and conservative.
An aggressive investor is one who has a higher risk tolerance level. In other words, he can invest predominantly into riskier asset classes such as equities and related products. A moderate investor looks for stability along with some growth in his portfolio while taking moderating levels of risk.
Lastly, a conservative investor is clearly risk averse and is willing to give up on high returns in order to lower his risk by sticking to those investment avenues which offer assured returns and/or capital protection.
Investors often incorrectly assess their risk profile and as a result, end up investing in asset classes that are not appropriate for them. Then again, it isnít uncommon for investors to get influenced by the noise around them and take on higher risk than they should. For instance, in rising markets, a risk-averse investor might invest a substantial portion of his portfolio (say 70%) in equities to make a quick-buck, and that too of the small/mid-cap variety, which is more volatile than blue-chip/large cap stocks. In this case, clearly, the investorís asset allocation is not in line with his risk profile.
Chasing higher returns while ignoring the associated risk will take you nowhere. In the same vein, being unduly risk-averse when one's goals and lifestyle demand higher risk may not be a smart move either.
Step 3: Define your financial goals
As investors, we all have our goals -both long and short term. It could either be providing for a marriage or your childís education, buying a car or a house or even saving for a holiday. Whatever be the goal or needs, they will help determine an individual's asset allocation and portfolio mix.
For instance, if you are planning for regular income post-retirement, you may decide on the fixed amount you would like to receive every year or month and plan your present investments accordingly. Here if the investor starts off his investments at a younger age, he may initially have minimal exposure towards debt instruments and a higher allocation towards equity. But as he reaches closer to his retirement, he would substantially reduce exposure to volatile asset classes and put that money into safer and more predictable instruments.
It is important to note that with changing times your goals or financial requirements will keep changing. Accordingly you will also have to review your portfolio and rebalance it at every stage of your life. At the same time reviewing is necessary to check whether the built portfolio is working for you as expected and if not, then there might be a need to relook at the components.
Step 4: Building a portfolio
After identifying your financial needs/requirements, on the next step is to build your portfolio. Expectedly, the portfolio needs to be customized according to the investorís needs. However, some investing thumb rules can serve as good starting points.
For instance: an aggressive investor can invest around 50-70% in equities and the remaining in debt. Similarly, a moderate investor may have 40% -60% in equities with the remaining in debt and cash/cash equivalents. And a conservative investor should typically have higher exposure towards fixed income instruments i.e nearly 60% - 80% with the remaining in cash with only a minimum in equity. Expectedly, over a period of time, as needs change, so will the portfolio. For instance, a young investor with minimal responsibilities might be game for an aggressive portfolio, however as the same investor grows older and takes up certain responsibilities, he might turn towards a different portfolio.
Asset allocation is the most important decision you will ever make for your investments and with that in mind, you may want to consider consulting a financial advisor to help you determine your asset allocation and for constructing an investment portfolio as well.