Importance of asset allocation

Tue, 17 Sep Pre-Open

   Previous Close   

   09:30 am   

   11:30 am   

   01:30 pm   

   Closing   

Financial planning is critical to generating stable long term returns. And the most important step in financial planning is asset allocation taking into consideration investor's risk and return requirements. While this may seem an easy task most investors fail to accurately assess their asset allocation requirements. Sample this. As per Reserve Bank of India's (RBI) latest annual report, investors put Rs 647 bn in bank fixed deposits last year! Not surprisingly bank Fixed Deposits (FD) constitute more than 50% of household investments in India. It becomes difficult to fathom that a country like India, whose long term growth story is pretty much intact, has 50% of investable savings parked in fixed deposits.

Ideally, in order to take advantage of the growth story investing in equities for the long term should yield better results, isn't it? Yet this is not happening in India. Why? The primary answer is low risk appetite of Indians and lack of awareness. Not many people are able to digest the volatility in equity markets despite having excess liquidity and age on their side. In short, they are unable to assess their risk return profile and asset allocation requirements. Another reason for this is also their investment horizon. Most view stock markets as a place to get rich quick. Therefore they are unable to cope with the volatility and ups and downs. As such, they continue investing in low risk assets like FD's despite their risk profile and asset allocation indicating otherwise.

This investing pattern indicates that Indian investors are risk averse. While looking for safety in investments is a wise approach, ignoring asset classes that can improve your return potential in future is poor asset allocation. Equities over the long term can easily generate returns that can beat FDs. Also, FDs have been poor in hedging inflation risk.

This indicates that investors have to reassess their asset allocation profiles. While FDs offer safety of investments and stability in returns, the asset class does not generate wealth over the long term after taking into consideration the impact of inflation and taxes. Equities, on the other hand, hedge inflation risk to a certain extent. However, it does not mean that investors should increase their allocation towards equities blindly. Equity allocation is dependent upon various considerations like age, liquidity, time horizon etc. If analysis of all these factors suggests that equities should be a part of the overall portfolio only then the exposure to this asset class should be increased. Also, within equities the investor should be broadly diversified amongst large, mid and small caps stocks. Gold is another asset class which should form a part of one's investment portfolio to.

In short, a proper investment portfolio is one which is diversified across asset classes and takes into account clients' risk as well as return considerations. Over exposure to a single asset class like FD in this case means that investors tend to lose out in the longer run.