Apr 10, 2013 | By Ranjeet S Mudholkar
Asset allocation is key to any investment strategy and it determines the returns a portfolio is able to generate over a period of time within an accepted range of volatility. According to a report published in the Financial Analyst Journal in 2000, asset allocation accounts for 90 percent of the variability in an investment’s performance.
Therefore it is critical that a prudent asset allocation is done at the time of portfolio construction. The question becomes even more pertinent in case of financial planning which involves achieving one’s life goals by managing his finances.
The goals need to be ascertained first and proper strategies developed to attain those goals. These strategies involve setting aside and investing some part of the current income stream for future welfare. However, the choice of asset class to invest depends on individual and his financial plan which is essentially a function of his / her life goals. Equity investment, being one of the highest returns generating asset classes, catches the fancy of most of the investors.
During a bull run, a lot of money is channelled towards equity markets. Equity being one of the most dynamic asset classes with high volatility in prices among the asset classes over a short period of time should be kept in mind while investing.
Thus, when it comes to investing in equity, one must be aware of both the aspects of equity as an asset class – its risks as well as returns. Among other parameters that are important to be evaluated when investing in equity is time. As a general rule, it is widely believed that equity investment is appropriate for the long term.
The definition of long term is relative and differs from person to person. Some Experts also interpret ‘term’ differently across various asset classes such as gold, real estate, bonds etc. However, this may not necessarily be the right approach. ‘Term’ should be applicable with reference to life goals, which should lay pathway for suitable investments, diversified over various asset classes, across different time horizons.
An analysis of historical data of returns from the BSE Sensex shows the rolling return for the index is the highest for a one year period while it goes on decreasing as the period increases, but at the same time volatility of the returns also decreases. Thus we could say that in the longer term, investment in equity market stabilises both in terms of returns and volatility and period of 5-7 years may be considered reasonable. However, the degree and proportion of exposure should be suitably assessed in order, which should be professionally evaluated.
Another benefit of investing in equity is the tax efficiency it provides to the investments. Investment in listed equity shares beyond one year do not attract any tax on capital gains while for the investments for the period less than one year are taxed at a short term capital gains tax rate of 15 percent. In addition, selected equity linked savings schemes (ELSS) of mutual funds are eligible for deduction under section 80C of Income Tax Act, 1961.
However, employing financial planning approach that advocates goal-based investing after identifying life goals gives clarity about the time horizon. Investment in any asset class should correspond to one or more financial goals being pursued.
Diversification into more asset classes can substantially reduce the associated risk as one nears the financial goals. Equity is an important asset class but needs to be used judiciously over different time periods corresponding to different life goals. In addition, it must be kept in mind that once the targeted return is achieved in accordance with the goal being pursued, profit needs to be booked and the investment could be migrated to a safer asset class.
In conclusion, we could say that for consistent risk-adjusted returns, time horizon in various asset classes must be carefully determined before arriving at optimum asset allocation to achieve a financial goal.
Strategies like Systematic Investment Plan (SIP) could be used for advantages like rupee cost averaging and regular investing. A similar strategy may be used while exiting the investments too so that the volatility and price movement can be negotiated with.
Diversification in time also plays an important role in addition to asset class diversification. Whatever may be the case, it is always advisable to decide the time horizon with a definite goal in mind. Taking the services of a qualified practitioner like a Certified Financial PlannerCM may help in this regard who can help the investor achieve financial goals by taking reasonable return from every asset class including equity.
The writer is the Vice Chairman and Chief Executive Officer Financial Planning Standards Board India (FPSB India). The views expressed here are personal, and do not necessarily represent that of the organization.
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