Risk and return are two sides of the same coin, and investors must determine how much risk they are willing to assume to generate the kind of returns they hope to achieve. The two fundamental questions investors must address, are the likely life expectancy of the investor (or couple) and the percentage of assets the person (or couple) expects to spend every year in retirement. In terms of the latter, If its 5 per cent, and your bank fixed deposit is earning 5 per cent, you are in trouble, Why Because of inflation.
Decisions about what constitutes the right or appropriate portfolio, a balance between the spending needs of the individual in retirement against the probable returns on a portfolio. Assuming that we can invest in four main asset classes ie, equities, bonds, real estate and cash, how should investments be allocated
Cash and cash equivalents should ideally cover for current expenses for two quarters with a buffer for emergencies. Cash funds are also excellent cash management tools that should be used for short-term tactical allocation. In the Indian context investment options in real estate are not really available to small investors. The transaction costs are comparatively high for direct investments in the absence of Real Estate Investment Trusts (collective real estate investment vehicles) which are popular internationally. A myth often quoted that 100 minus your current age would tell accurately what percentage of your assets should be in equities.
In reality, this maybe too conservative. With the average life expectancy of someone at age (64) being about 20 years, if you had only 36 per cent of assets invested in equities, inflation at 10 per cent plus would eat away your assets.
Oversimplification is the easiest way to respond, but in reality, your asset allocation should depend on current net worth, costs to be borne (college expenses, weddings, etc.), insurance position, debts and expected remaining lifetime. Generic investment styles are passe asset allocation will increasingly be driven by the desire of a certain lifestyle. Ideally, by age 50, assuming you have 10 years to retirement and no remaining major family expenses, you must be well insured to cover all debts, and should earn enough to continue adding to your portfolio age appropriately.
In the current dynamic and volatile investment climate any asset allocation should be rebalanced based on economic conditions. Portfolio rebalancing is also a good way to maintain risk-return parity among various asset classes.
Think of the markets as a two-way street and like your mother probably used to say, always look both ways before crossing a busy street. Rebalancing is also a good way to take some money off the table when times are good and assets are expensive, so that you have money to invest when they are not and assets are cheaper.
I believe setting a long-term strategic allocation as well as a short-term tactical allocation plan always gives the best results. The long-term strategic allocation should be always be focused on the big picture of risk versus return, and the short-term tactical allocation must be used to reduce risk.
Why equities The case for long-term investment in Indian equities have never been more compelling: with a targeted 7 per cent plus GDP growth, improving float versus market capitalisation, higher transparency and corporate governance, high dividend yields, low p/e ratio for FY 2005 and record low interest rates 10-year yield at 5.93 per cent, 20 per cent plus Sensex earnings growth for FY2005 and 2006.
Investors would do well over the medium term to allocate a large percentage of investable funds to equities. As clearly seen in graph this is a unique opportunity for investors. The low p/e combined with 20 per cent plus sensex earnings growth is a tempting cocktail which has been recently spiked with zero long term capital gains and 10 per cent short term capital gains. Market timing must be left to the experts.
As shown below trading and losing track of long-term goals only make you lose long term capital growth opportunity. As Ben Graham said: In the short run, the market is a voting machine but in the long run it is a weighing machine.
The author is COO of IL&FS Investsmart and can be contacted at firstname.lastname@example.org