Understanding asset allocation and diversification
The idea of balance is fairly deep in our psyche. We balance the activities of sleep, work, leisure, eating, etc; we balance our career with family life. Similarly, finance recommends that we balance the way we hold our assets. This process of thinking about how we balance different ways we hold our wealth, is called asset allocation. The different ways themselves are asset classes.
Instead of putting ad-hoc money into different products that capture our attention, a smarter way is to think of this allocation first. If we find too much money lying in cash and nothing in real estate, we could then look for opportunities in real estate. There is no dearth of ideas, dogmas and methods to go about doing this. But the first step is really to get used to thinking about wealth at an overall level. And getting used to planning from that starting point, rather than acting ad-hoc as we usually do.
Reading some financial literature or product brochures, you could be forgiven for thinking that asset allocation is some esoteric concept with a lot of mathematics and complexity. Brokers, who may variously call themselves advisers or agents, often wax eloquent on how their product does automatic asset allocation for you. The self-chosen plans are even worse, with large tables indicating how your money could be split between debt and equity. All this may justify a broker’s existence, but it certainly is not useful for you.
As we’ve said before, asset allocation is the simple process of having a balanced financial diet, similar to how you mix food-stuffs in your eating. Too much of one, and you are asking for some disease or the other over time. And this is not only about debt and equity, which is what most financial products offer. It is simply making sure your net worth has various different components to it – a house, some jewellery or gold, equity, bonds, cash in the bank account, maybe a plot of land, etc.
You usually keep aside something for short-term or unforeseen expenses. You then keep the rest of the savings for the long term – some distant goals, retirement or even general wealth building. Asset allocation, at its simplest, just means that you take no risk with the short-term stuff. Let it lie in bank accounts or debt in any other form. You necessarily take risk with the long-term stuff, putting it in equity, real estate or gold. If you ignore the former point, you risk not having money ready when you need it. If you ignore the latter (i.e. by not taking risk), you risk eroding your wealth over time due to inflation.
Another common problem is what products to go for. This depends on how much time you can devote to personal finance, or how interested you are in devoting time to it. If you have no time or commitment to personal finance, invest through mutual funds. The dedicated fund managers there do your work for you, at a small fee. If you have the passion and time, you can do your own research – look for a multi-bagger stock, bet on a plot of land, get a beach-front villa or even buy a painting.
All these require commitment and interest, and not everyone has them. Once you have decided on your mix based on the horizon consideration given in the previous paragraph, it is simply a function of your interest.
Both the above factors (the horizon and product choices) are important, and it is critical you do not get carried away by one at the expense of the other. This usually happens when you buy any product based on an advertisement or broker push, without looking at the horizon. It also happens when you have too strong a passion (e.g. stock trading), that blinds you to the overall context of your wealth.
The good news is that there is something in the market for everyone – the non finance types, the passionate, the retired and the young. If you are simply aware of your own preferences and the context, you can choose wisely.
The author is a director at Fintotal Insights and Resources Pvt Ltd
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