Gauge your risk profile, choose the right mix

Risk and reward are integral parts of investment. High reward entails high risk and low risk assets provide low returns. The big question is how to get decent returns with little risk. This is where diversification and asset allocation help us. We will discuss asset allocation in this article.

The purpose of asset allocation is to reduce the overall risk by investing in different financial asset classes. This is a very effective tool for investors to reduce risk. Everyone should have a portion of his investments into different asset classes. Usually equity, bonds, and cash are traditional classes for asset allocation. Additionally, these three classes of assets don’t have much correlation with one another, which means market movements do not affect them in the same degree.

Investment alternatives
Investors have used traditional classes of assets such as equity, bonds, and cash since long. However, there have been new alternatives coming up in the area of real estate, commodities, venture capital, private equity, precious metals, antiques, and natural resources. These assets have given tremendous returns in good times but have high risk/reward portfolio. Not many people are comfortable investing in alternative asset classes as these are new areas and have high risk. Some people term it as speculative investment.

How to choose the right allocation
In the late 90s, when the technology sector was hot, many people invested all their savings in technology stocks. One day the market crashed and millions lost their years of savings. This is an example of bad asset allocation.

Choosing the allocation depends on many factors. The most important factors are your age and risk profile.

Your age
The most important factor is your age. Relatively younger people who have more number of years remaining in their working life can take a higher risk and can invest a higher percentage in high risk assets such as equity and equity-oriented mutual funds. On the other hand, people who are near retirement should not take the risk of investing a major part of their money in equity. A higher percentage in bonds and saving accounts is preferable.
The rule of the thumb is that you subtract your age from 100 and that is the percentage you should invest in equity. So if you are 25 years old, you can invest 100-25 = 75% of your money in equity and equity-oriented mutual funds.

Risk profile of individuals
The other important factor is one’s individual risk profile. Some are naturally inclined to take a risk while majority are risk-averse to various degrees. A risk-averse individual should invest little of his or her money in equity. Risk profile plays an additional role in defining the percentage allocation to different financial asset classes.

Points to remember:
Asset allocation is a must. There are times when we confuse our gains due to a bull market with our genius in stock picking. This makes us more exposed to risk. Avoid this temptation. More money is lost in the Dalal street because of overconfidence than because of any other reason. Choose the right mix of equity, debt, and cash.

Always have an emergency fund beyond your asset allocation money. When we discuss asset allocation, we assume that you have set aside a good amount for any emergency. Never touch the emergency fund for investment.

Asset allocation is very individual in nature. For example, an investor with good experience may invest 80% of his portfolio in equity and just 10% in bonds and feel comfortable about it. It is also possible that another individual of the same age may invest only 50% of his/her portfolio in equity and 30% in bonds. Do your own research and study to find out what suits you. You can also consult financial planners, read investment books or do some research online on investing to understand your risk profile.

Finally, asset allocation is a dynamic concept. As you get older, you should rejig your portfolio to suit your time horizon. For example, when you are 25 years old, you can afford to have 75% of your money in stocks. When you reach 35, check your portfolio and change accordingly. The other time you need to rejig your allocation is when the percentage of one asset class goes beyond a limit because of market fluctuation. For example, if you have invested 50% of your money in stocks and it has gone to 70% because of a bull market, you should sell some of the stocks to get it to the comfortable level or buy more of the other asset classes to balance the portfolio.

The writer is CEO of BankBazaar.com, an online marketplace for personal, home and car loans.