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Designing A Goal-Directed Portfolio

| 6/14/2012 9:00 PM Thursday

For your investments to meet your goals, they must strike the risk-reward balance. Use asset allocation and diversification as guiding principles for your investment decisions.

Key Points:

  • While it is true that if you don’t take enough risk on your portfolio, higher returns would remain a distant dream, at the same time, taking too much risk may turn your dreams into your worst nightmares.
  • Asset allocation is an important strategy, as is proper diversification within an asset class. This helps to reduce your portfolio risk and minimise the impact of any negative performance in either a sector/ industry or an investing style.
  • As different asset classes behave differently over time, a carefully designed portfolio can help in managing market risk efficiently. As your investment time frame and goals change, so should your asset allocation.

Many investors aspire to earn supernormal returns. While aiming to earn higher returns is not strange, the problem arises when investors wish to earn these returns without taking even normal risks associated with investment that have the potential to provide higher returns over the longer term. As a result, their actions often belie their aspirations.

It is quite common to see a complete mismatch between how investors design their portfolio and what they intend to achieve through it. The resultant desperation makes them take abrupt investment decisions. If you are among those investors who face this situation often, you need to wake up to the fact that the key to investment success lies in striking the right balance between risk and reward.

While it is true that if you don’t take enough risk on your portfolio, higher returns would remain a distant dream, at the same time, taking too much risk may turn your dreams into your worst nightmares. This is where an asset allocation strategy has a role to play. Asset allocation is the process of combining various asset classes such as equity, debt, real estate and commodities into a portfolio. This strategy helps because if one asset class is losing money, the other may bring you good returns.

On the other hand, if a substantial part of your portfolio consists of securities belonging to a risky asset class like equity, the end result can deviate substantially from your expectations over the short-to-medium term. Considering that asset allocation is the most important factor in determining the kind of returns you can get from your investments over time, it must be the mainstay of your portfolio.

Asset allocation is a form of diversification that reduces your portfolio risk more than it compromises returns. When you invest in different asset classes that tend to go in opposite directions in different market conditions, the combination is likely to have a stabilising effect on your portfolio. For example, the stock market does well during an economic boom and loses ground during recessionary times. The bond market, however, has the opposite trajectory – while recessionary conditions are good for the bond market, a booming economy is not so favourable for it.

It is equally important to ensure proper diversification within an asset class. When you diversify your investments, you reduce the chances of your portfolio suffering from the risks associated with having concentrated holdings. In other words, diversification helps in minimising the impact of any negative performance in either a sector/industry or an investing style.

For your asset allocation strategy to be successful, it must be flexible enough to accommodate changes in your financial circumstances as well as those in the economic cycle. This is important because the economic environment has a direct impact on the behaviour of financial markets.

It is crucial to keep certain key points in mind while deciding your asset allocation and practicing it over a period of time. The key ingredients should be your time horizon, investment goals as well as your risk tolerance. As different asset classes behave differently over time, a carefully designed portfolio can help in managing market risk efficiently. As your investment time frame and goals change, so should your asset allocation. Therefore, be prepared to re-evaluate your asset allocation periodically.

It is equally important to adopt the right strategy for investment in line with your asset allocation. Once the asset allocation is in place, the focus should be on selecting the most appropriate investment options. For example, for a small investor who doesn’t have the wherewithal to invest directly in the stock market, mutual funds can be an ideal option. The key considerations while selecting investment instruments must be their flexibility, transparency, tax efficiency and liquidity.

Don’t forget, the most important factor is to get started. Remember, it is never too late to start as well as to revamp your asset allocation plan.

Hemant Rustagi
CEO, Wiseinvest Advisors

 

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