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Wednesday, October 19, 2016

Investment - Eggs and Baskets

Do not put all your eggs in one basket. We heard this from time immemorial. This is frequently quoted whenever we discuss the topic of asset allocation. Let us look deeper into the characters of this story - namely eggs and baskets.

Eggs are nothing but my investments (amount of money that I am going to invest) and baskets are different asset classes (debt, equity, hybrid, gold, real estate etc.)

Who came first - egg or chicken? Mystery unsolved. But when we talk of asset allocation we know the answer. Eggs came first. And depending on the number of eggs (amount of money to be invested), baskets are chosen. Not the vice versa. The amount of money that you are going to invest - you will invest that anyway.Because that is your investible surplus - you cannot increase that and you should not decrease that. As far as choice of basket is concerned it depends on many things and hence can be little complicated at times.

Let us talk of two scenarios here:

Mr. A can invest Rs. 1 lakh now and also Rs. 20 thousand every month. He does not have any critical goal left to map with this investment. All his goals are either fulfilled or are already taken care of. He just wants to see his money growing. At this scenario Mr. A has ample choices to make. He may decide to invest fully into equity (if his risk appetite is high) or fully into fixed deposit (in case of low risk appetite) or into an appropriate mix of debt and equity (moderate). So choice of basket is entirely at Mr. A's discretion.

Mr. B can also invest Rs. 1 lakh now and Rs. 20 thousand every month. But he has goals to achieve - short term, medium term as well as long term goals. Let whatever be Mr. B's risk appetite - he doesn't have much choices. For short term goals he cannot put his eggs in a basket which can shake anytime. Similarly for long term goals even if he wants to invest only into FD - he may not be able to do so - as he may fall short of his target. If that happens then he will have to either increase his investment amount or adjust his target to a lower level. If none of these is possible then he has no choice but to choose the optimal set of baskets suitable for him.

The crux of asset allocation lies in minimizing risk. If my different asset classes respond differently to a particular event – then my overall portfolio is in a very healthy shape. Lesser risk needs not necessarily lead to lesser return but assuming a realistic return from the portfolio is a very important step while planning investments. If that means more amount of money to be invested – check if you can. If not, then adjust your goal amount. Somewhere somehow you have to strike a balance, otherwise get ready for a nasty surprise. No one knows, what future will turn out for us. But if you assume a lesser return than the market standard and also set a higher target value for your goal – and your investible surplus matches the requirement – then chances are more that you will achieve your goal comfortably.

What should be the right mix of assets for a goal? There is no right or wrong answer here. It depends on many factors like – thecriticality of the goal, your overall net-worth, market trend, available investible surplus, your understanding about different asset classes and so on.Still if we try to present a standard set of rules for asset allocation (which may or may not fit your particular case – hence it is highly recommended that you contact your financial advisor for the same) that may look like this:

If my goal is very short term (< 1 year), I should not look beyond pure debt instrument with assured return.

If my goal is short term (<=3 years), majority of my investments should go into debt and/or hybrid instruments.

If my goal is medium term (<=7 years), 50 to 70% of my investments can go into equity and the rest(30 to 50%) into debt/hybrid instruments.

If my goal is long term (> 7 years) majority of my investments (70% or higher) should go into equity and rest into debt/hybrid.

Also remember here that a long term goal does not always remain long term. A goal which is 10 years away from now – is surely a long term goal today. But after 7 years from now that same goal will turn medium term and thereafter short term. So we have to change asset allocation accordingly.

[While we talk of assets, it should be noted that 'mutual fund' as a whole doesn't fall in any asset class. It can take different shape (equity, hybrid or debt) depending on your choice of schemes.]

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