Saturday, March 28, 2009

Asset Allocation

Financial planning

Subsequent to my last blog post, I had a couple of friends asking me as to what an ideal financial plan looked like. Well, there is no ideal financial plan! There are plans that talk of what’s best for a typical investor. But you are not a typical investor, you are you! So, at the best you could have a few thumb rules, but there is no substitute for working with your financial planner in developing a plan that works for you. In this blog, I discuss some of the thumb rules.

Taking stock

Before you start off on putting together the plan you need to know what your financial position is. You need to have a handle on your assets, liabilities, income and expenses. This is no rocket science. Just make a list of the things of value you own, things like your house, stocks and bonds, MF investments, bank deposits, PF balance, etc. Similarly list out all the loans you may have taken. Then look at your income, include salary income and regular income from all other sources. Finally, look at your expenses. Make a distinction between your discretionary and non-discretionary expenses. The former are expenses that you should be willing to forego to hasten your journey towards financial freedom. This could, for instance, mean cutting down on the number of restaurant visits, watching that latest movie at home rather than at the multiplex, etc. Please be easy on yourselves as you do this. Cutting out all the spend on recreation – for instance- may make the journey towards financial freedom appear as not being worth the trouble.

Asset allocation

Now that you know where you stand financially, you need to set your financial goals and allocate investments to achieve those goals. Asset allocation plays an important part here. It is often tempting to go after the latest buzz and invest in an asset class that has performed the best recently, like equities and real estate in India, till 2008. As people that bought stocks or real estate – for investment- in early 2008 will attest, this can be a recipe for financial disaster. Putting all your eggs in one basket is seldom a good idea.

The basic idea behind diversification is that different asset classes react differently to economic events. For instance, when an economy is contracting, corporate profits fall. Demand for office space falls too. This is bad news for stocks and real estate. Demand for money comes down and interest rates fall, pushing up the bond prices, which is good news for those investing in debt. Similarly, when an economy is in the upswing, the reverse could happen, when stocks and real estate outperform debt. Thus, there are times when one asset class does better than the rest. As almost no one can time the entry into and exit from asset classes successfully, it may make sense to diversify across asset classes.

The asset classes 

The asset classes that an individual investor most commonly looks at are stocks, real estate, gold

 and debt – including cash. Please note that I don’t include insurance here as I don’t look upon insurance as an investment. Insurance is protection against unforeseen events. So, include the cost of insurance in your expenses. Don’t look upon that as an asset.

There is no magic allocation formula – that says x% should go into equities, y% into debt and so on. Be extremely wary if your financial planner uses a pre-built model to calculate the asset allocation for you. It makes no sense and it amazes me that almost all financial planners take this route. I am making this statement based on my personal experience.

I was once sitting with a seriously rich guy and there were these banks presenting to him, proposing to help him manage his money. One of the banks suggested that he should have 40% of his money in debt, as he was 40 years old! A number of planners use this thumb rule that one should have (100-x)% in equity and that was what this banker was using. This guy was worth many a million dollar at that point in time and 40% of his wealth in debt would have given him interest income which was probably 10x the amount of money he expected to spend annually. That would have been an extremely sub-optimal arrangement. If this is the depth of analysis that the planner was willing to do, when they were dealing with such a rich person, you can imagine what kind of thought goes into planning support for you and me. So, you need to take charge and make sure that your planner explains to you why he is suggesting a particular model. Make sure that you are comfortable with the same.

Once you have decided on the asset allocation, you need to make reasonable assumptions about the kind of returns you should expect from each one of the asset classes you would have decided to invest in. As Mark Twain remarked, “History does not repeat itself, but it does rhyme”. So, past returns over a reasonable long period of time – say over the past decade- should be a good indicator of the returns you should expect.

With your asset allocation decided and return expectations built in, you are on track to know how close you are to achieving financial freedom. I have designed a spreadsheet that lets you determine this. Please send a mail to and I will happy to revert with the same.

I will discuss the rationale for investing in each one of these asset classes in subsequent posts. Till then!


Please note that the information contained and provided in this blog is of a general nature and it is not my intention to provide any professional advice, solicitation or offer to sell, recommend or purchase securities and/or funds to the readers of this blog.

Please exercise due caution and verify any and all information sought to be relied upon and/or seek independent professional advice before entering into any commercial or business relationship or transaction with any person or entity, and /or any other party or make any investment or enter into any financial obligation based solely on any information, statement or opinion which is contained, provided, posted or expressed in this blog.

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