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Asset allocation and goal-based financial planning

Let me begin by throwing some light on what are assets. In simple language, assets are something that carry the potential of giving returns in either of the 2 forms:

1. Capital appreciation

2. Regular steady cash flows by way of dividend, rent, interest etc

Let’s take a simple example of a residential property. When you invest in a house, it carries the potential of giving you rent on a monthly basis. If everything goes well, that house is likely to sell after few years for a price higher than what you purchased it for (called as capital appreciation).

The real growth in an individual’s financial position comes from capital appreciation. For this simple reason, if you have inherited a house from your earlier generation, the price for which it sells today is much higher than what your ancestors have paid for! It may not be wrong to say that your ancestor’s vision of buying the house has helped you today in realizing that capital gain. Once that house is sold, it is up to you how you want to use that money. You could buy another piece of property or you could invest that into a financial asset.

At this point, let me distinguish between financial assets and physical assets. As the name indicates, physical assets are the ones you can touch and feel. On the other hand, financial assets do not offer the same experience. Gold, real estate are classic examples of physical assets. On the other hand, fixed deposits is a classic example of financial assets.

Financial assets are of various types again. Fixed deposits is the simplest to understand because it does not have the uncertainty in itself. If you deposit Rs. 1 lakh with a bank today, it will pay you 5-6% interest per annum. On the maturity of the fixed deposit, the bank will simply return your capital (Rs. 1 lakh) to your account. What we are discussing here is the concept of fixed returns vs capital appreciation. Fixed deposits promise you a fixed return by way of interest, but there is no element of capital appreciation.

Let me come to bonds now. Bonds are a type of financial asset that guarantee a fixed annual return (called coupon). However, the principal value of a bond keeps fluctuating (based mainly on interest rate in the economy). Comparing a bond vis-à-vis fixed deposit, a bond promises fixed returns, but at the same time the principal (capital) is likely to go up or down. This is unlike fixed deposits, where the capital does not appreciate or depreciate.

It’s time to talk about equities or stocks. Just like bonds, the unit prices of stocks fluctuate depending on multiple factors. Within equities, there are some companies that pay regular dividends. Most of the companies pay little or no dividend at all. As you must have guessed it by now, companies that pay heavy dividends generally do not offer good capital appreciation. Companies that do not pay dividends generally end up reinvesting all the money into their business. This reinvested money helps further in growing their business and hence the stock price appreciates accordingly with improved business performance.

We have discussed enough about the types of assets. It is time to summarize the classic trade-off between regular fixed income and capital appreciation.

It is important to note here that selecting the type of asset class depends on 2 factors:

1. How much risk can you take on the said capital?

2. What is the objective behind your investment?

The second bullet points brings us to the topic of goal based financial planning. Let me give you an example:

Daughter’s education: If you want to start saving a fixed some of money per month for your daughter’s education, which is the best investment? The answer to this question depends on whom do you ask this question. If you ask it to an insurance agent, he will say insurance policies are best investment vehicles. If you ask this question to a real estate broker, he may tell you to invest a lump-sum amount in a house that she can liquidate later and use the proceeds to fund her education. What we are talking here is ‘conflict of interest’. Advisors generally suggest instruments in which their income gets maximized.

Now think about this logically. If your daughter is currently 6-7 years of age, it’s likely that you are planning for her education which is at least 10-12 years from now. When the duration of your goal is long enough, the biggest threat to your objective is ‘inflation’. Inflation is an unpredictable economic variable and it is extremely difficult to predict how it will behave over a period of 10 years. In order to ensure that you do not end up compromising your daughter’s education, you must have the objective of beating inflation by a handsome margin. The best hedge against inflation is investments in equities. This is a historically established fact.

The question that now arises is how about the risk in equity investments. Sometime ago, we said that equity is a risky asset class. What sense does it make to invest in a risky asset class for an important goal like education? Well, the answer lies in the duration of the goal. Since her education is 10-12 years from now, the risk gets reduced. Equity markets are extremely risky in the short term, but are more predictable over the longer term.

It is time to now summarize the article. Selecting an asset class for investment depends on the following factors:

  1. Investment objective/ Goal: There are different goals like retirement planning, child’s education, buying a luxury car, buying a second home, child’s wedding etc

  2. Risk taking ability: Goal carrying higher priority generally have a lower risk appetite.

  3. Underlying goal and duration of the goal: Short duration goals have a lower risk appetite.

  4. Priority of the goal: Education for your child is a higher priority goal than buying a luxury car.

Some common mistakes that people generally make in asset class selection:

  1. More comfort with physical assets than financial assets: There is nothing like one type is superior to another. What generally happens is people are more comfortable with assets that they can touch and feel. This makes financial assets difficult to understand and hence a majority of the people shun away from financial assets. However, the reality is that asset class selection should be based on goal priority, investment objective, goal duration and risk taking ability.

  2. Over exposure to a particular asset class: More comfort with physical assets than financial assets has an important implication. Many-a-times investors end up having over exposure to either real estate or gold. This may or may not be a good choice of asset selection. As we have seen earlier, funding your child’s education requires beating inflation by a handsome margin. Assets that seem simple may or may not achieve this important objective.

  3. Not having wealth creation as an ultimate goal: Once you allocate money to all your stated goals, it is time to think about creating wealth for your forthcoming generations. Wealth creation takes time and the best time to start is NOW!

Goal based financial planning helps you in selecting the right asset classes in required proportion. You definitely do not want to jeopardise important goals like your child's education by investing in extremely risky stocks. Similarly, you do not want to be too conservative by parking your money in gold/ real estate. Taking the help of a financial advisor will help you get clarity in your mind as to how you should plan your finances. In case you are convinced about planning your finances well, feel free to get in touch with us here .

I hope this article helps you better in planning your finances. All the best!

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