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Set financial goals before investing
Asset allocation is a process where you need to answer a few short questions. These could include: What percentage of my portfolio should I invest in equities? How much of it should go into bonds? How much should I hold in cash?
Asset allocation starts with determining your investment objectives, that is, the goal of your investment and your risk profile, which is a combination of your risk taking capacity and ability.
Know the difference
Risk-taking capacity is determined by your financial position: You may not mind losing a lakh of rupees if your net worth is Rs 10 crore. But losing the same amount may be substantial if your net worth is Rs 10 lakh. Risk-taking ability, on the other hand, is independent of your financial position and has a lot to do with your mental ability to cope with losses.
Simply put, determining your risk profile is asking yourself the amount of money you are willing to lose without getting sleepless nights. The losses you can bear before starting to get uncomfortable is a key determinant of your allocation to risky assets like equity .
The age factor
Your age could be a factor that can influence your risk taking ability. It has led to proliferation of models which suggest that investment in equity as a percentage of the portfolio should be 100 minus your age. That is, if your age is 40 years, you can have 60% of your portfolio in equities. However, it's important to remember that age is not the only determinant of one's risk profile as it does not take into account the emotional aspect of an individual.
I have known many individuals who at an age of 25 do not like losing a single rupee and put all their money in bank fixed deposits. The way age influences asset allocation is that your requirement for steady income from financial assets increases once you retire. This requirement can be better met through income-yielding assets like fixed deposits, debt mutual funds, bonds, etc.
Investment objective
Investment objective is the other factor that influences asset allocation. It is important to determine whether the ideal asset allocation based on your risk profile is able to meet your stated investment objectives. Here, expected returns from various asset classes should be critically assessed. Long-term historical returns from an asset class can be a good starting point to make this assessment, keeping in mind the standard disclaimer that an asset's past performance is not an indicator of its future returns. In case your investment objective is not being met based on your asset allocation, the option is either to save more or be more realistic in terms of your goal.
Time horizon
Time horizon for investment is one key parameter to consider while deciding your asset allocation. Studies have shown that you have rarely lost money in a diversified portfolio of equities in India if your investment horizon is more than 10 years. So, the longer your time horizon for investing, the more you can invest in some of the riskier asset classes.
Liquidity
The need for liquidity is an important aspect to keep in mind while making any asset allocation plan. The portion of the portfolio that might be needed to take care of any financial exigencies needs to be kept in liquid funds or bank fixed deposits.
The mistake most people make is to invest all their financial savings in equity or real estate, only to realize later that they need the money within six months. You might be lucky to make some decent returns in equity during that time frame. But, most of the times, it results in heartburn as you exit the investment at a loss.
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