|
| How much debt, how much equity? |
 |
 |
Rattan Chugh
ExpressMoney
Tuesday, December 26, 2006 at 1045 IST
There are three things you need to think through to arrive at an asset allocation that services your financial needs and suits your temperament.
The significance of asset allocation has been well established. Various studies have shown that long-term performance of a portfolio is primarily driven by strategic asset allocation.
|
Security selection and market timing have a minimal long-term positive impact on returns, even as they end up increasing the time and money spent in managing a portfolio.
Asset allocation is a strategy that helps you invest your savings across different asset classes, to maximise your projected returns and manage the risk within your level of tolerance. It also reduces volatility within your portfolio, as asset classes tend to perform differently over a period of time. So, if you have a well-diversified portfolio across equities, debt and real estate, a sharp decline in, say, the real estate market will not have a significant impact as compared to in a portfolio that is dominated by real estate.
While drawing up an asset allocation strategy for yourself, you need to assess three aspects: time horizon, desired rate of return and risk tolerance. |
| |
| Time horizon |
| |
Your age is a key parameter in determining your asset allocation. When you are young and starting out, you have time to plan for your major financial goals such as marriage, house, children’s education and retirement. Your potential to earn future income is also the maximum at that time. With time on your side, you can deal better with the higher risk that equity carries, as your portfolio has sufficient time to recover from temporary dips in value. As you start approaching the age of retirement, your potential income reduces and the need to protect the assets you have accumulated is higher. Therefore, your ability to tolerate higher risk is significantly reduced.
The equity portion in the portfolio provides the potential for long-term growth, while debt-based products provide income and risk reduction. One of the basis for computing your preferred allocation to equities a simplistic one, though is to subtract your age from 100. So, for example, if you are 35, your allocation to equities is 65 per cent (100-35) |
| |
| Return objective |
| |
As you identify your short-, medium- and long-term goals, you will be able to compute the level of return that is required to meet the goal. Your return objective depends on the size of your portfolio, liquidity requirements, impact of inflation and tax implications. Say, you have a bank deposit of Rs 4 lakh set aside for your daughter’s wedding. Assuming an interest rate of 8 per cent and inflation at 5 per cent, the amount available to you after five years will be Rs 4.6 lakh. This is a pre-tax figure. If this is insufficient to meet your goal, your expected rate of return has to be higher unless you are ready to add more funds to the kitty (See table: Time is money).
|
| |
As you identify your short-, medium- and long-term goals, you will be able to compute the level of return that is required to meet the goal. Your return objective depends on the size of your portfolio, liquidity requirements, impact of inflation and tax implications. Say, you have a bank deposit of Rs 4 lakh set aside for your daughter’s wedding. Assuming an interest rate of 8 per cent and inflation at 5 per cent, the amount available to you after five years will be Rs 4.6 lakh. This is a pre-tax figure. If this is insufficient to meet your goal, your expected rate of return has to be higher unless you are ready to add more funds to the kitty (See table: Time is money). |
|
 |
|
| |
| Risk tolerance |
| |
Your risk tolerance depends on your willingness and ability to take risk. Your age, number of dependents, job security, personal experiences and level of wealth determine your ability to take risk. Psychological factors help understand your risk attitude and decision-making style. Your reaction to fluctuations in the value of your portfolio determines your ability to take risk. If you are constantly anxious about your portfolio and its movement, it’s a sign that your portfolio is too risky for your profile.
There are online tools available on websites of financial services companies that help you ascertain whether you are a conservative, balanced or an aggressive investor.
A lot of us who have been used to the earlier bank fixed deposit regime, where one could earn 10-12 per cent for near zero risk find it difficult to settle for a 7 per cent return, but at the same time find it difficult to take higher risk. Risk and return go hand in hand. The higher your risk tolerance, the higher is the potential return that you should expect. A systematic approach with proper financial planning can help you maximise the expected rate of return for the level of risk you are willing and able to take. Remember: chance favours the prepared mind.
|
| |
| |
|
|
|
| |
| Home |
| |
|
