Why Asset Allocation is the most important money management decision?
Updated: Feb 3, 2020
When it comes to managing wealth, there are two types of decisions one must take:
Macro Decision: How much money to hold in different types of assets such as real estate, stocks, bonds and cash? (Asset Allocation)
Micro Decision: Which specific piece of land, or stock/fund, which deposit in what bank, etc. to buy?
While we spend majority of our time debating the micro decisions, hardly anyone focuses on the more important decision of asset allocation. Most Indians would have never put on paper the different assets they hold and in what quantum, hence they are never aware of their own asset allocation or the rate at which their overall wealth is increasing/decreasing year on year. Even if you are one of the exceptions who knows the overall diversification, you might be extremely over or underweight certain asset classes.
Let’s see why this is a problem:
You purchased shares of a company a few years ago and it turned out to be a spectacular performer. Your stock grew five folds and your small investment is now substantial, you feel great about it. But if this stock is still less than 1% of the wealth you own, what difference did it make to your aggregate assets and life? Marginal, at best. This is why asset allocation matters.
It is easy to forget the bigger picture of your overall wealth growth when you are micro focusing on what a particular stock or fund gave you.
It is easy to lose track of the big picture that determines how our wealth is growing and how the different assets are contributing to it. Mention asset allocation, and most investors think it is a topic for classrooms, and represents theories about investments. Practical, real-life stories are about actual picks and their performances, they argue. But this is not true.
Why undertake asset allocation?
The above chart helps us understand the following:
Different assets perform well over different periods of time. Everything does not go up together, and everything does not go down together.
There are no consistent patterns or predictive values from one year to the next.
No asset performs consistently year after year.
Since we do not know in advance which assets will be the best performers of the year, it is prudent to hold a little bit of all of them.
Historically equity has beaten all asset classes over long periods of time. However one must have debt holdings so they can tide over volatility in equity, without putting their entire capital at risk.
Asset allocation in bonds and gold will allow you to protect your downside instead of risking your entire portfolio in real estate or equity. At the same time asset allocation will allow you to diversify in alpha generating asset classes like equity, upto your risk appetite.
The point of the illustration is that you MUST diversify meaningfully in: Real Estate, Domestic Equity, International Equity, Bonds/Debt Funds, Gold and any other asset class that works for you. It is the key to steering through every market condition.
Such a portfolio may not deliver the highest return in any given year, but will perform competitively across market cycles over the long run.
How to do it?
So how do you know whether you have enough or too much or too little in any asset?
An easy way to begin is simply write down the asset classes that you have, the total current value held in each asset/it’s percentage proportion of your total wealth, and the rate of return for the last one year. The weighted average of all components will be the overall return of all your wealth.
Disclaimer: This is NOT a recommended asset allocation specifically for you. It is only a representation of how asset allocation can be done and how yields from different assets contribute to your overall wealth growth.
Undertaking this simple activity provides the much needed 360° view of your wealth and assets. You can then understand the risk and returns from different asset classes and modify the proportions by moving money around or making additional contributions.
There is no perfect formula for asset allocation. It is extremely personal depending on financial goals, quantum of income, frequency of income, current asset holdings, risk appetite, liquidity requirements, etc.
But the point is to know what you hold and what purpose it serves in your overall wealth creation story.
Few pointers while implementing asset allocation:
It is advisable to create minimum and maximum threshold limits for yourself in each asset, which would help you from being over or under weight in any asset class in the future.
Also make sure you are not omitting any major asset classes, such as equity as a whole.
Once the assets are invested as per optimal asset allocation, they need to be rebalanced periodically to ensure that you stick to your original long term plan.
There is no need to be exact about the proportion or rework it too often. What is required is a general sense of asset division, being diversified and realising that your aggregate growth depends on all your assets working, not just one.
Segregate and know that financial planning is a two step process
Marco Asset Allocation Decision
Micro Asset Specific Decisions. You might take excellent micro asset decisions of picking the correct stocks and funds, at the correct time, but they will not matter if your macro asset allocation is done incorrectly.
Do not Randomly Invest. Do not be over or under invested in any asset class. Create a structure with maximum and minimum percentage holdings in each major asset class to guide your investment decisions.
Do not skip major asset classes all together (for example: international equity or bonds).
Asset Allocation does not help generate the highest returns, but the most consistent returns over a long period of time.
Hope this article will encourage you to undertake a broad assessment of your current asset allocation.
If you need help devising an asset allocation plan or have any questions about the same, feel free to contact us.
"The difference between success and failure is not which stock you buy or which piece of real estate you buy, it's asset allocation." - Tony Robbins.