Asset allocation and how to use it to reach your financial goals

In simple terms, asset allocation is defined as dividing your portfolio among the different investment categories available such as stocks, bonds, real estate, gold, crypto, cash, etc. By understanding the concepts behind asset allocation, you will understand the right mix of assets you need to invest in to achieve success in both your short-term and long-term goals.

What is an asset class?

To understand asset allocation, we have to wrap our heads around what an asset class is. In simple terms, an asset class is a group of investments with certain common characteristics that behave similarly to each other.

Consider the different tech products you use in your day-to-day life, like your mobile phone, laptop, television, and so on. Even though you can watch your favourite Netflix show on all of these devices, each device has its individuality and serves a different purpose.

What are the different types of asset classes?

Throughout recent history, there have been five major types of asset classes. They are:

• Equities (Stocks)

• Fixed Income (Bonds)

• Real Estate (REITs and residential/commercial property)

• Money Market Instruments (Cash and cash equivalents)

• Commodities (Gold, silver, oil)

Next, let's take a quick look into each asset class and how it can help you achieve your financial goals.

• Equities (Stocks): Owning stock or a share in a company (directly or through mutual funds) means you are a part-owner of the company you invested in. You get returns in two ways:

  • A rise in the stock price.

  • A company issues dividends/stock buybacks. Dividends are distributions of company profit.

• Fixed Income: This category includes assets like Fixed Deposits, Government Bonds, RBI Bonds and other corporate deposits and bonds. Fixed-income assets generally pay a set interest rate for a specified period and then return the investor's capital after the period is completed.

• Commodities: Commodities include physical goods like gold, copper, crude oil, natural gas, wheat, corn, and even electricity. During periods of high inflation, gold prices go up, so you can use it to reduce the overall risk of your portfolio. You can also use commodities to diversify your portfolio as the returns of gold do not move in accordance with the returns of stocks and bonds.

• Real estate: Traditionally, real estate meant land or commercial/ residential property, but you can also invest in real estate by buying REITs. A REIT is a fund that owns, operates, or finances income-generating real estate. You can invest in publicly traded REITs on the stock market or invest in REIT mutual funds/ETFs. You can view real estate as an asset class that provides diversification, is resistant to inflation to a certain degree, has low liquidity (challenging to buy and sell quickly), and generates moderate returns.

Which asset class has given the best historical returns?

The real estate and stock market have produced the highest returns over time.

For real estate, we do not have a central record system for historical returns. However, people who have invested in it got wealthy in 15-20 years.

The stock market is different. It is tracked, and various laws have been formed to ensure compliance and safety. If we started our journey of investing in the early 1979s, the CAGR (compounded annual growth rate) of the Sensex has been about 17%, assuming all dividends are reinvested and adjusting for inflation.

Stocks can be highly volatile in the short term, and the key is giving them time to run by overcoming the urge to sell during short-term volatile periods. The Nifty50, for example, is far less reliable over any 12-month period, meaning you face a greater risk of losing money.

However, when you stretch the holding period to five years, you're far more likely to make money. So, the longer your holding period is, the more likely you will make money in the stock market.

Why are asset classes useful?

Asset classes can help you diversify your investment portfolio to maximize your returns based on factors like your tolerance for risk, financial goals, investment objectives, investment time horizon, and preferences towards certain types of assets.

Investing in different asset classes enables you to ensure a certain diversity in your investments as each asset class has different characteristics and behaves differently in any given market environment.

How to allocate assets to meet your financial goals:

Now that you know about the different asset classes and how you can leverage them to achieve your financial goals, we can start thinking about allocating your investments across various asset classes.

The answer to the question of how to allocate assets is the dreaded phrase: "It depends.". However, we can look at some of the factors you must consider when deciding how much of your portfolio you can dedicate to each asset class.

Some of the factors you have to take into consideration while allocating your assets are:

• Age and time horizon: Age plays a significant part in deciding your asset allocation in your retirement portfolio. If you are in your 20s and 30s, you have plenty of time to wait for investments to grow or recover from setbacks. This means you can afford to allocate a large percentage of your portfolio to riskier assets like equity and cryptocurrencies. The main goal in this stage is wealth-building, so you should try and take on enough risk to achieve higher returns.

  Suppose you're in the 30-to-50-year-old group. Now you have less time to recover if things go sideways. In this case, you should reduce the riskiness of your portfolio by lowering allocation to riskier investments like stocks and cryptocurrencies and increasing allocation to steadier ones like bonds and money market instruments.

  Finally, suppose you're an ageing investor (above 50). Now, time is against you, as you have very little time left for either growth or recovery. In this case, you should slowly begin moving the majority of your portfolio towards debt or fixed income instruments, which will serve as a replacement to your active income as retirement draws near. At this stage, your main goal is preserving the money you have and using your investments as a source of income.

  Along with age, the time horizon of your goals determines how much you should allocate to riskier asset classes. If you have a long time horizon for a particular goal (like retiring in 30+ years), then you can afford to invest in more volatile assets like equity as they have higher expected returns in the long run. Investing in Index funds and total market ETFs can be an excellent way to achieve your long-term financial goals.

  However, it is not advisable to invest in risky assets for short-term goals (where you might require your investment within the next few years) as it results in speculation and can cause permanent loss of capital. Instead, to meet short-term financial goals, it is advisable to invest in fixed income assets or money market instruments.

• Income: The amount of money you invest is directly proportional to your income. Any boost in your income in the form of bonuses, appraisals, promotions, switching jobs, or building different income streams can help you achieve your financial goals faster by investing more of your income in dollar terms.

• Number of Dependents: If you have several dependents, you need to invest more of your income into short-term investments. There might be several recurring expenses with a short time horizon, like educational and medical expenses. In such cases, you should make sure you have enough liquidity either by holding cash or by investing in short-term money market instruments.

• Expenses: To improve your financial health and achieve your goals, you must keep your expenses in check and live within your means. Removing extravagant and unnecessary costs can go a long way in ensuring that you reach your financial goals on time. This practice can help you save a large portion of your monthly income, which you can then invest in suitable asset classes.

• Income Stability: The COVID-19 pandemic has opened our eyes to the realization that income stability is of utmost importance, especially in troubling times. Job security, type of employment, regularity of cash flows, and other factors play a vital role in asset allocation.

  If your income is irregular, you can allocate a higher percentage of your portfolio towards liquid assets. However, if you have a job that gives you a constant stream of income, then you can increase your allocation towards riskier assets like equity and cryptocurrencies.

• Risk Appetite: Your risk appetite (that is, how much risk you’re comfortable with or desire to take on) should be an amalgamation of all the above factors as it depends on your age, income, savings rate, income stability, and time horizon. Suppose you are a young professional with a moderately high income, low expenses, and no dependents. In that case, you can afford to allocate a high percentage of your portfolio to riskier assets like stocks and crypto. Some people are more risk-averse than others and should dedicate a smaller portion toward equities and crypto. Your risk appetite is thus a combination of the factors mentioned above as well as your willingness to take risks and face volatility.

Improvements in asset allocation:

If you have 90% of your net worth in real estate —> Liquidity issues may arise or low returns could be there for a really long period.

If you have 90% equity assets, market correction may hurt badly.

You could have REITs more if you prefer real estate a lot. Otherwise equal allocations in real estate and equity and some portion in fixed income and gold.

If you have more inclination towards equity, you can introduce thematic funds like healthcare or services and global funds as well.

Whether to invest in Crypto?

Whether you believe in cryptocurrencies or not, based on your risk/reward parameters, you can allocate a small part of your portfolio towards riskier asset classes like cryptocurrencies such as Bitcoin and Ethereum.

Just be aware that due diligence is necessary before investing in any cryptocurrency. Understanding the underlying blockchain technology, use case and what each crypto project is striving to achieve is essential before investing.

Final Thoughts and Wrap-up:

Even though we've covered so much, it’s important to remember that the asset allocation you choose will depend on your personal preferences and environment. A simple rule of thumb: allocate your assets so that it helps you sleep well at night and make money when you sleep.

The stock market is trading at an all-time high, and at Fincare, our study shows that we are likely to scale new highs every couple of months.  

There are a few reasons for that and the most compelling reason is the strength of Indian investors and consumers. When income increases, it goes towards either consumption or investment. In either case, it is beneficial for equity investors. Rs. 200,000 SIP in the next 10 years could become Rs. 5.5 crores.

If you want to know where to invest right now, let’s discuss one-on-one.

You can also read on How parents used mutual funds to send their daughter to IIM-A? and Equity investing for millennials.