Uma Shashikant, TNN | Oct 13, 2014, 07.11AM IST | Times of India

It is not easy to convince an investor that asset allocation is the best way to build long term wealth. It is really tough to tell even a dear friend that she should not seek out products, but take a more holistic view.There is simply no time to worry about these things, and as long as the product seems good, it should be fine. Whenever she calls, it is about investing some spare money. Sometimes, she provides me with a list of names and asks me to vet them for her. She is actually not interested in any conversation beyond this. Why should it matter?

There are no investors, at least none that I know of, who have all their money in a single product. Even those that buy property have some balance in the bank, their Provident Fund (PF), tax-saving funds and insurance policies, and some gold in the locker. Yes, that is asset allocation for you. Except that it is not to any specific design, but mostly built by default. How much you hold where will affect your financial lives the most–in terms of risk, return and all else that you care for. Investment products are but minor details in this big picture. What is wrong with asset allocation by default?

The assets that we hold should ideally match our needs, and we should know what we intend to do with them. This is the gist of the financial planning framework. Since all money is not earned and consumed today, and since tomorrow might hold needs that require funding, and since some of these needs would be much larger than our small monthly incomes, we all need financial planning. This activity can get as elaborate as you wish, or as simple as the allocation between assets that earn an income and assets that grow in value over time. Why is this distinction important?

Assets that provide an income stream are meant to serve short-term needs. They will typically feature low and steady return, mostly matching inflation rates, and preserve the invested capital. Assets that grow in value are meant to serve long-term needs. They will grow at a rate that beats inflation, but feature higher short-term risks to the invested capital. These are like batsmen and bowlers in a cricket team–and every team needs a combination of both to win. How tough is this to implement?

There are three broad combinations. An investor who primarily needs growth, should have 70% in growth assets and 30% in income assets.Investors, who have a steadily increasing income stream that takes care of most needs, should look at this combination. Investors who primarily need income should have 70% in income assets and 30% in growth assets. Retired investors are classic examples. Without the 30% in growth assets they will lose any edge to fight inflation. Those that are unable to decide one way or the other, or think they need both should do a 50:50 in income and growth assets.

My friend can use equity for growth and debt for income. An equity index fund and two diversified equity funds are more than enough.The index fund is her protection against selecting wrong funds and suffering as a consequence.The diversified equity funds provide the midcap, small-cap, sector stock and all such additional benefits. There is no need to buy one of each kind, assemble them all together and find that the return is about the same as a diversified equity fund. The safest income asset she can buy is debt issued by the government. The Public Provident Fund represents a fairly simple option with a good return. Its limitation is that it is not too liquid. The same is the case with PF. She can add some bank deposits to earn a bit more as interest, and two debt funds to earn any additional market income and enjoy some liquidity . One all-purpose debt fund called dynamic, flexible or any such name should serve her purpose. Any cash she has will be in the bank or in a liquid fund. That makes it five income products. But, my friend feels buying different products is nice, doing a few things over and over again is boring. Why is she wrong? The more the products she piles on, the higher the possibility that her return will be just about average. She now buys a different tax-saving fund each year. She obliges her advisor by buying a few New Fund Offers. Then she gets worried investing in the same thing and seeks new names when she has the money to invest. The end result is that she holds more than 15 different equity mutual funds. It is very likely that her return is just about the return on a broad equity market index, which she could have bought at a fraction of the cost she is paying for all the funds she holds. Investors fail to see how diversification works. If you hold too many choices, you are unlikely to benefit majorly from a good choice–or be hurt badly by a poor choice. You will stay at the average. So what should she do?

She should stick to an investment plan that assigns money to these options every year.There is no need to book profits, time the markets and sweat about what is going wrong. She has to do two things though. First, check, at least once a year, if the products she has chosen are still good. Second, switch from 70:30 to 50:50 and to 30:70 as her needs change. She can do this herself. If she finds that bothersome, she can ask her advisor to do it for her. Every investor’s core portfolio can be constructed in this manner. Rest is pure adventure!

Source : http://goo.gl/5HYbc6