HOW TO INVEST YOUR MONEY? AN ASSET ALLOCATION PERSPECTIVE
The basics first - The asset classes
To have a lively discussion about where to invest, you’d first have to know about the different asset classes available and their characteristics. Here is a look.
There is a whole science behind asset allocation. But we are going to cut the complexity out so that we have a barebones approach. This should do for most people. If you are interested, you can always ask us for more!
Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in your investment portfolio according to your risk tolerance, goals and timeframe. In other words, it is the process of allocating different percentages to different asset classes in your investment portfolio based on your risk tolerance.
Risk tolerance is divided into two parts –
- Risk-taking ability – If you are 30 years old with a stable job and plenty of savings, your risk-taking ability is quite high. If you are 70 years old, retired and living off of your pension, your risk-taking ability is quite low.
- Risk Aversion – If you’ll lose sleep looking at your investments go down in value during a bear market, you are quite risk-averse. If you’ll still manage to sleep well no matter the markets, you aren’t as risk-averse.
Given that high returns usually come with high risks, the first rule in the guidebook says that you should evaluate your risk tolerance to determine how you should be investing your money. If your risk tolerance is low, stick to risk-free investments and expect to make no more than 6% in the current climate. That’s the end of it.
HOW TO MEASURE RISK TOLERANCE?
How do you feel about this?
Your total investments went down from Rs.100 to Rs.60 within a month.
- If you said, ‘Not too bad. I have a regular income and I have money set aside for my other immediate needs. As long as the portfolio value can recover over the long term, I am ok with it’, then your risk tolerance is very high.
- But if you said, ‘That’s too steep a drop. I can take it if it goes down to Rs.80 from Rs.100. But no more than that.’, then your risk tolerance is moderate.
Here is a table showing the list of maximum possible drawdown in value your investments could suffer in any given month at different asset allocations.
Find the maximum drawdown in value that you can stand to see and pick the appropriate guidance for % of investments in risky and risk-free asset classes listed against it. For example, if you are extremely risk averse and cannot stand to see any reduction in your portfolio value (of say Rs.100), then your ideal asset allocation mix is 10% risky assets and 90% risk-free assets. If on the other hand you are ok with taking some risk and can stand to see your portfolio value drop from Rs.100 to Rs.80 (worst cast scenario), then your ideal asset allocation is 55% risky assets and 45% risk-free assets.
Assumptions – Max equity drawdown assumed at 40%, risk-free rate assumed to be 6%
Did you notice how even a totally risk-averse investor can have a 10% allocation to risky assets and not suffer from any drawdown? How does that work?
- Let’s assume that such an investor starts the year with Rs.100 and invests Rs.90 in fixed deposits and Rs.10 in stocks.
- Let’s assume that at the end of the year, stocks go down by 40% in value (Rs.10 goes down to Rs.6).
- His fixed deposits on the other hand will give him a guaranteed return of 6%(Rs90 goes up to Rs.95.4).
- His total invested value will still have gone up from Rs.100 to Rs.101.4 – No drawdown.
OK GREAT! HOW DO WE APPLY THIS?
Take a walk with us along the streets of Mumbai and we will show you how!
INVESTING IS AS SIMPLE AS TAKING A WALK ALONG THE STREETS OF MUMBAI. COME ALONG WE WILL SHOW YOU...
And that’s it. Keep it simple. Keep it real. But have a method. And more importantly, make it a habit. Before you know it, you will have stopped worrying about money. If you are after an even simple method to investing, read our post on goal-based investing right here.