Asset allocation, Diversification and Risk Management

We all intellectually know, the all too obvious Personal Finance Equation:

Savings = Income - Expenses

It is obvious that in order to increase savings we need to Increase our Earnings and/or decrease our expenses.

With the savings that we got, if we don't invest it properly, Inflation will ensure that we are poor for the rest of our life.

As an example, a flat (apartment) that costed Rs. 30 Lakhs 5 years ago near our locality, costs more than Rs. 90 Lakhs, in this downbeat economy today (in 2009). That is more than a 300% increase. Remember, we are talking Bangalore.

Let us say, that I had Rs. 30 Lakhs 5 years ago. If I had invested in that property, I would have made close to 300% profit before taxes. Of course, this is not a guaranteed return, and there are years when house prices drop big time. This doesn't factor the depreciation costs for the house also. These 5 years just happened to have been good overall.

If I had parked the money in the bank as a Fixed Deposit @ 8% for 5 years, that amount would have become approx Rs. 44 Lakhs, before taxes (assuming compounded interest).

If I had let it stay in a savings account @3.5% interest, it would have become Rs. 35 Lakhs in 5 years.

If I had invested it in stock market, depending on my portfolio and the state of the economy, the amount could have gone up by a certain % or it could have gone down in value also. It's hard to predict the exact return.

The message is clear. Greater the risks, greater the reward.

The more conservative you are, the returns are somewhat predictable, but may not keep with inflation. If the inflation in the past five years is 4%, then even if you get a guaranteed 8% annual return in a Fixed Deposit, your effective actual return is only (8 - 4 = ) 4%.

Inflation explains why and how your great grand parents who were getting a few hundred Rupees a month or year were able to lead a decent life, save and were even able to afford housing in their lives. It explains how You, having an exponentially higher income than them, still end up solving the same (or more) problems that they were trying to solve.

Asset allocation: We all allocate in our day to day life in some shape or form. If you are a home maker, you allocate your budget for the kitchen across groceries, milk, vegetables, fruits and meats. If you are a professional, you allocate time for work vs family, you allocate money for entertainment, education, groceries,kids etc.,. If you are a student, you allocate time for studies vs. play vs rest.

Asset allocation is similar and simple. Given your age, investment potential and risk tolerance, how do you allocate your investment as to get maximum or optimum returns, especially over the long term? Asset allocation is determining the right mix of asset classes for your investments. One that balances risk and rewards.

Is there a standard rule of asset allocation that will fetch maximum returns ? No. Are there some rules of thumb/guidelines? Yes.

In the US, the rule of thumb they apply is to subtract your age from 100, and invest that much percentage of money in stocks. Going by this formula. if you are 25, you can invest up to 75% in stocks, and the remaining in relatively safer instruments.

The reasoning is that when you are in your 20s, you have a longer time horizon. Therefore you are better able to withstand even wild swings in the stock market, and are not in a hurry to sell when the markets are down. As you get older, your risk tolerance reduces and hence you move to relatively safer instruments like Fixed Deposits that give you more guaranteed but lower returns.

But India is not a developed market. We are not a fully capitalist society. The stock market is much more volatile. I tend to use 75 instead of 100 (to factor in fluctuations and risks). For e.g. in my world, if you are 25, you can invest up to 50% in stocks/mutual funds.

If you are more conservative than me, then use 60% or even 50% depending on your preference and risk tolerance. But have atleast 20-25% of your money invested in stocks and mutual funds atleast until you are 50. If you are more aggressive than me, by all means stick to 100 - your age formula.

Asset Classes: There are too many asset classes that keep popping up every day for me to list all of them (e.g. commodities) in a blog. Granted some of them are confusing and risky to invest in, unless you are a pro.

In general, I have the following rules: If I don't understand or believe the ingredients of a food, then I don't eat the food. If I don't understand or believe the investments, then I don't invest in them.

What you see in the picture at the top, are broadly the asset classes, that you need to be aware of. We'll discuss them at length later. For now, just the concept is sufficient. Note that I've deliberately not provided any % of allocation, as it depends on your age and risk tolerance.

Diversification: This is very closely related to Asset Allocation. It represents one more level of how you spread your investments within each asset class so as to minimize and spread your risks.

For e.g. within Real Estate, you can invest in Residential and/or Commercial Real Estate. Within Stocks, you can invest in various classes of stocks. E.g. Technology, Manufacturing, Health Care, Retail, Automobile, Bio-Tech are some examples. Within Fixed Deposits, you can invest in Post Office deposits vs. Bank Fixed Deposits vs. PPF.


What if I allocate but don't diversify? You ask. Back in mid 1990s, many of friends invested heavily in NASDAQ (US Stock system that tracks technology stocks). Being techies, they thought they knew Tech stocks.

They enjoyed a great ride for the most part of 90s, when many technology stocks split and/or provided great returns (sometimes as much as 100% or more).

But then when the dot com bubble bust in 2000-2002, several tech stocks went belly up. Many of them lost incredible amount of hard earned money, sometimes their principal.

If they had diversified and invested in other types of stocks also (in addition to technology stocks), their overall return might have been lower, but their returns would have atleast been protected by the upswing in other types of stocks like manufacturing or health care. At the very least, the losses would have been lower.

The point of Diversification is that, when the stock markets go down, the bonds, and short term, Fixed deposits may hold up well, protecting your overall portfolio and thus giving you the required financial and emotional strength to ride over the rough patch.

When tech stocks down, for example bank stocks may do well that particular day offsetting your losses. If the entire stock market is down, bond markets may be up or gold may be up. Atleast they may not be all down by the same magnitude. When residential real estate may be losing value, commercial real estate may move up and make your day.

Risk Management: Many of us wrongly assume that the stock market is risky or real estate is risky. Fixed Deposits feel safer. I would like to emphasize that this is only a feeling and not so much truth.

Risk is only a relative term. Granted that your principal is safer in many fixed term instruments like NSC (National Security Certificates), or Fixed Deposits.

However if the inflation is high year after year, your buying power goes down significantly with time. If your investments don't earn handsome returns as with bank deposits, you really lose money in inflation, life style terms. Is that not a huge risk in itself?

In the flat example quoted above, if I had left the money in any other instruments (than buying the property in 2004), my position to buy a flat in 2009 would have been much weaker than in 2004. (Let me remind you. I didn't have 30 Lakhs, and I didn't invest it anywhere. The flat price is true though ).

Stock markets sure go through wild swings. It is scary to see your portfolio's value go through wild gyrations (specially if you are one to watch your portfolio every day). However, if you are invested for the long term, stock markets (on the right kind of stocks or indexes of course), have historically been proven to produce exponentially higher returns than relatively risk free securities/ Fixed Deposits.

In their white paper about ,The Equity Premium, published by Rajnish Mishra of UC, Santa Barbara and National Bureau of Economic Research , they argue the case for the above fact and produce the following figures, based on RBI Data:

Real Terminal Value of Rs 1 Invested
Investment Period	Stocks (BSE 100)	Bank Deposit	Ratio
1984–2004	Rs 19.25	Rs 1.28	15.04
1991–2004	Rs 4.68	Rs 1.18	3.97

I hope this puts the definition of Risk in its perspective and convinces you to consider the stock market favorably, as a significant part of your Investment Strategy.

In other words, you can't eliminate risks by staying away from the stock market altogether. But you can manage the risks, by applying serious thoughts on asset allocation and diversification. And then once or twice a year, say during your birthday and/or Diwali, you should review your portfolio and re-balance if necessary.

Note that I'm not discounting Fixed Deposits or PPF or NSCs or arguing against them. In fact, you very much need those as well.

The question is in what ratio you allocate and diversify your various assets. The answer depends on a lot of factors including but not limited to your age, risk tolerance, investment objectives (do you want to turn a millionaire by 40 and/or do you want to save for your kids school and/or do you want to plan for your retirement? etc,.), the priorities of these investment objectives, your commitments in life, your values etc., That's something you can get addressed for your specific personal situation, by reading up good Finance Literature and hearing from Professional Financial Planners and/or Experts, that don't have any vested interests in selling you any specific product. They should genuinely care about you and your Financial Welfare (More on that later).

What if I don't have that much money to invest in all these asset classes? you ask. We'll see the detailed answer later, but you have mutual funds, Systematic Investment Plans, Recurring deposits that can get you started with as little as Rs. 500 a month. You need to have the grit, knowledge, discipline and willingness to take a plunge.

I want you to note one thing. You may mistakes in the process of following these strategies. You could even lose some money. Warren Buffet has made mistakes. No one is immune to losing money or making mistakes.

Rest assured, the learning out of these mistakes are invaluable. You should do it in such a way, that you minimize your losses and maximize your gains. You should do it such that in the long run, you are able to meet or beat your objectives. That's the whole objective of Personal Financial Management and that's one of the reasons I started this blog.