Asset Allocation And Diversification For Long Term Wealth Creation

Even beginner in investing knows some fundamental principles of sound investing. How do you think you learned them? Through real-life experiences that have nothing to do with the stock market.

Example of asset allocation & diversification

For example, have you ever noticed that street vendors often sell seemingly unrelated products - such as cold weather hoodies, woolen clothes, and light cotton summer wear? Initially, that may seem odd. After all, how would a person buy both clothes at the same time? Probably never - and that’s the point. Street vendors know that when it’s cold, it’s easier to sell cold-weather clothes but harder to summer wear. And when it’s summer, the reverse is true. By selling both items - in other words, by diversifying the products - the vendor can reduce the risk of losing money on any given day earning something respectable.

If that seems logical to you, you are starting to understand asset allocation and diversification. The article talks about Asset Allocation and Diversification & how it helps create long term wealth managing Risk.

Asset Allocation

Asset allocation involves spreading your investment among different asset categories, such as stocks, mutual funds, bonds, gold, real estate, NPS, and cash to balance the risk and earn high respectable returns over the long term. The asset allocation that works best for you will depend largely on, the time horizon (long is better) and your risk appetite.

Time Horizon

Time horizon is the expected period you will be investing money to achieve a specific financial goal. An investor with a longer time horizon can comfortably take more risk with more volatile asset classes because he or she can wait while those slow economic ups and downs of markets. An investor with a long time horizon also balances his portfolio over the period and gets time to correct any error he makes while investing even he gets any small losses. But an investor saving up for a foreign trip after 5 years, would likely take less risk because he or she has a shorter time span.

Risk Appetite

Risk appetite is your capability and readiness to lose some or all of your original investment if there is a greater possibility of high returns. An aggressive investor, or one with a high-risk appetite, is more likely to risk losing money in order to get better returns. A conservative investor, or one with a low-risk appetite, tends to prefer investments that will preserve his or her original investment. 

Risk versus Reward

When it comes to investing, risk and reward are inseparably interlinked. All investments involve some risk. If you intend to invest in stocks, bonds, or mutual funds - it’s important that you understand before you invest that you could lose some or all of your money.

The reward for taking on risk is the potential for high investment returns. If you have long-term financial goals, you are likely to make more money by carefully investing in asset categories with greater risk, like stocks or mutual funds, rather than restricting your investments to assets with less risk like cash, FDs, Postal schemes, etc. On the other hand, investing solely in FDs, cash investment equivalents may be appropriate for short-term financial goals.

Investment avenues

While no one can recommend any specific investment asset category will benefit you the most, you should know that there are lots of investment products exists - including stocks, mutual funds, corporate and Government bonds, exchange-traded funds, Gold, Real estate, etc.

For many financial goals, investing in a mix of these categories can be a good strategy. Let’s have a closer look at the features of the major asset categories.

Stocks

If we see history, Stocks have the highest potential to beat inflation and get high returns involving great risk. As an asset category, stocks are a portfolio’s main driving element offering the greatest potential for growth. The volatility of the stocks market makes them a very risky investment asset class in the short term. Investors that have been willing to wait and sustain the volatile returns of stocks over long periods of time generally have been rewarded with great returns. The only thing is Investor needs a good financial advisor or he should learn to do a fundamental analysis of the company he is investing in. Otherwise, the risk of losing money also is great if investor depends on tips and financial news channels. Another thing is to get successful investing in stocks needs a big diversified portfolio of stocks which is very difficult to manage for the normal retail investor.

Bonds

Bonds are generally less volatile than stocks but offer respectable returns. As a result, an investor approaching a financial goal might find it wise to increase his or her bond holdings relative to his stock holdings. You should keep in mind that certain categories of bonds offer high returns similar to stocks. There are mainly two types of Bonds, Corporate bonds and Government bonds.

Cash & equivalents

Cash and cash equivalents - such as Senior citizens' savings deposits, National Saving Schemes, Fixed deposits are the safest investments but offer the lowest returns than other major asset categories. The chances of losing money on an investment in this asset category are generally extremely low. The principal worry for investors investing in cash equivalents is the Risk of inflation since this investment class does not have the potential to beat inflation.

Mutual Funds

Mutual Funds is a pool of money managed for the investor by the Fund Manager investing in a big diversified portfolio of stocks having certain predefined objective and philosophy. The investor can take the benefit of professional management at a low cost. The options like Systematic Investment Plans (SIP) can give you help you get discipline and automation in your investment by deducting a certain fixed amount of money automatically from your bank amount for investment. This is the best investment avenue for investors who don't have the experience and time to manage their money by themselves. They can go direct or through a Mutual Fund distributor/advisor. Mutual funds have another important benefit that you can have the choice to diversify your money with different types of mutual funds such as Large-cap funds, large & midcap funds, small cap funds, debt funds, hybrid funds, flexicap funds, etc.

Gold

Gold is an evergreen and popular investment class for Indians. We buy gold as jewelry on different auspicious occasions, as a gift, etc. We can also buy coins, gold biscuits as an investment. There are other options like paper Gold or Gold ETFs which reduce the risk of physically storing the gold.

Why Asset Allocation Is So Important

By including asset categories in your portfolio with investment returns that move up and down under different market conditions, an investor can protect himself against considerable losses. Historically, the returns of the major asset categories have not moved up and down at the same time. Market conditions & demands that cause one asset category to do well may cause another asset category to have average or poor returns. By spreading your investment in more than one asset category, you’ll reduce the risk of losing money and your portfolio’s overall investment returns will have respectable gains over a long period of time. If one asset category’s investment return falls, you’ll easily balance your losses in that asset category with better returns in another asset category.

Determining the appropriate asset allocation for a financial goal is a complex task. Basically, you’re trying to pick a mix of assets that has the highest probability of meeting your goal at a level of risk you can live with. As you get closer to meeting your goal, you’ll need to be able to balance the portfolio.

If you know your time horizon and risk appetite - and have some investing experience - you may feel comfortable creating your own portfolio with the right asset allocation. There is no one right asset allocation that is right for every financial goal for a particular individual.

Some financial experts believe that determining your asset allocation is the most important decision that you’ll make with respect to your investment portfolio. It is important to consider asking a financial advisor to help you determine your initial asset allocation and suggest rebalance for the future. But before you take the help of anyone to support you with these enormously important decisions, be sure to do a thorough check of his or her credentials. He or she should be licensed & registered to respective financial institutions.

Diversification

The practice of spreading money among different investment asset classes helps reduce risk is known as diversification. By picking the right group of investments as per your risk appetite & investment horizon, you may be able to reduce your losses and fluctuations in your investment returns.

In addition, asset allocation is an important factor in deciding whether you will meet your financial goal & beat inflation. If you don’t include enough riskier asset classes in your portfolio, your investments may not earn a large enough return to meet your goal. For example, if you are saving for a long-term goal, such as retirement, most financial experts agree that you will likely need to include at least some stocks or equity mutual funds in your portfolio. 

The Connection Between Asset Allocation and Diversification

Diversification is a strategy that can be neatly summed up as, “don’t put all your eggs in one basket.” The strategy involves spreading your money among various investment avenues in the hope that if one investment loses money, the other investments will help balance overall returns.

A diversified portfolio should be diversified at two levels: between asset categories and within asset categories. So in addition to allocating your investments among stocks, bonds, cash equivalents, mutual funds etc., you will also need to spread out your investments within each asset category. The key is to identify investments in segments of each asset category that may perform differently under different market conditions.

One way of diversifying your investments within an asset category is to identify and invest in different market caps of companies and industry sectors. But the stock portion of your investment portfolio won’t be diversified if you only invest in four or five stocks. You will need more than twenty carefully selected & studied individual stocks having growth potential to be truly diversified. That is why debate happens often "Mutual Funds vs Stocks".

Because achieving diversification can be so difficult, some investors may find it easier to diversify within each asset category through investing in mutual funds rather than through individual investments. Mutual funds make it easy for investors to own a small portion of many types of asset classes.

We cannot predict the "Black Swan" events as explained by Nassim Taleb, a finance professor, writer, and former Wall Street trader. Taleb wrote about the idea of a black swan event in his book. Taleb asserted that because black swan events are impossible to predict due to their extreme rarity but they may have catastrophic consequences. It is important for people to always assume a "Black Swan" event like a pandemic, world financial crash is a possibility and investors should try to plan accordingly. Some financial experts believe that diversification may offer some protection in such situations.