Sunday 24 February 2008

Introduction to Asset Allocation

Introduction to Asset Allocation

I've received a few phone calls suggesting that the term "Asset Allocation" may perhaps be a bit too complex for some beginners. They suggested that I give a primer. One of them has challenged me to write about Asset Allocation in a manner which can be understood by a teenage kid.

Here's my attempt:

Assets are of different kinds - You can keep your savings in a variety of forms - Some examples:

  1. Cash
  2. Savings Bank Account in a bank
  3. Fixed Deposit with a bank or a company
  4. Gold bars, biscuits, etc.
  5. Jewellery
  6. Investment in Public Provident Fund, LIC Money-back policies
  7. Mutual Funds
  8. Shares
  9. Investment in Real Estate (buying a house, plot, etc.)
  10. Investment in Antiques, Art, etc. (like buying a painting by MF Hussain with a view to selling it a few years later at a huge profit)

Each one of the above has its own advantages and disadvantages. I'll take just three of the above (No. 1, 6 and 10 in the above list) as examples to explain the concept of Asset Allocation.

Suppose we have some surplus funds of a few thousand rupees.

If we keep the entire amount as cash, the advantages are:

  • We can spend it whenever we want, without any problems.
  • There is no risk of the cash losing its value due to general uncertainties (except due to inflation)

Disadvantages:

  • No returns - cash kept in a purse or handbag (or under the pillow) does not generate any additional income, unlike other forms of saving the money mentioned in the list above
  • Inflation erodes the value (Rs. 1000/= could buy much more in the year 1998 than in 2008, for instance)
  • Risk of being lost
  • Chances of being spent off on somewhat unnecessary expenses.

If we invest the amount in Shares (basically shares represent part ownership of the company whose shares are being held by us), it results in:

Advantages:

  • Generates periodic income by way of dividends as and when the company declares dividends
  • Generates additional income by way of Capital Gains when we sell the shares

Disadvantages:

  • If we want to buy something with the funds invested in shares, we can't do so unless we sell the shares and convert it into cash (this disadvantage is call illiquidity)
  • Share prices can go (up or) down quite significantly. We can even lose the entire money invested in shares (This can happen even by investing in good companies - Ask the people who invested in companies like Infosys or Wipro in 2000 who had to wait for a few years before their share prices reached the same levels again) - This is called "Market risk"

If we invest the funds in buying a painting by a budding artist, it results in:

Advantages:

  • Generates income only by way of Capital Gains as and when we sell the painting at a higher price, years later. However, if we are smart in identifying the right artist and buy the painting at the right price, the gains can be huge.
  • Snob value by hanging the painting on our walls to "Show off"

Disadvantages:

  • If we want to buy something with the funds invested in art or antiques, we can't do so unless we sell the shares and convert it into cash
  • Very difficult to sell - Highly illiquid - Sometimes impossible
  • Market price of such paintings is highly uncertain and unorganised. Completely unpredictable. 

I've just mentioned some of the advantages and disadvantages. Obviously, it does not make sense to keep all our surplus funds in any one particular form of assets in the list mentioned at the beginning of this page.

Depending on the requirements of each individual, we'll probably have to keep some funds in the form of cash, but the rest of our surplus funds must be invested in one or more of the forms of investment mentioned above. This process is called  "Asset Allocation".

What percentage of one's surplus funds should be invested in different types of assets mentioned above? That would be determined by various factors, including:

  • Age of the person
  • Financial position of the person
  • Risk-taking ability
  • Desired income / returns from the investments
  • Time horizon of investments (short-term vs. long-term)
  • Awareness and Understanding of different types of assets

More details on the modalities of actual "Asset Allocation" for a specific individual will have to be identified on a case to case basis.

Something topical for the more advanced readers who may find the above stuff too basic and not worth the bother:

 

Nice to know that Anil Ambani has taken care of Reliance Energy Shareholders as well.

 

Moreover the bonus ratio also seems to be quite liberal compared to expectations.

 

But nevertheless, I'm uncomfortable about the fact that Anil Ambani is treating "non-promoter" shareholders differently - Equity shares are among the riskiest class of assets. Such being the case, such actions tend to create a scenario (unreal, nevertheless) that IPO investments, especially in ADAG group IPOs are somehow "not risky". I think that in the long run, it would have been better for the investors to have suffered the losses than get such placebos! Wonder how many of the Reliance Power investors would agree with me?!?!?

 

Do keep the comments flowing in!

Regards,

N


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