In my previous article,I wrote about the power of passive income. Surprisingly,investors either do not plan to earn it or do so in a haphazard way. Buying stocks randomly on tips,selling these on a small profit,investing in inappropriate products being sold aggressively,contemplating to invest in all sorts of real estate or illiquid structured products are a few examples. But why do investors not plan? There are three reasons. Firstly,investors are not aware of the power of passive income; they are surprised that it can exceed active income. Secondly,investors find it difficult,risky and time-consuming. Markets could be volatile with Sensex going up by 500 points one day and going down the next day. They get confused with medias uncanny ability to explain both sides of the move rationally. Thirdly,human mind is wired for immediate gratification. Different areas of brain,get stimulated when an individual is thinking of buying an attractive car; the same areas remain unenthused when thinking of saving money for the future. However,there is a simple solution. The power of passive income can be harnessed by implementing just two steps. Setting goals Targets increase the probability of achieving goals. Setting financial goals is a very useful step in making investments systematic,with simple calculations showing where the savings should go. Worthwhile goals help overcome the natural instinct of immediate gratification. Just classifying them as short-term and long-term goals is a huge help in determining where the money gets invested. Bank deposits and short-term debt funds are good for the short term,while long-term money should go to higher yielding but volatile classes like stocks and real estate. Asset allocation Research shows that asset allocation determines 95% of a portfolio return while selection of individual securities accounts for the rest 5%. But generally,an investor spends his time in the opposite way; he is focused on individual securities or stocks while ignoring macro asset allocation. Asset allocation is the process of determining asset classes in which savings should be invested,and in what proportion. Different asset classes include stocks,real estate,fixed income securities,small savings schemes,structured products,commodities and international securities. For example,if an investor has Rs 100 to be invested every month,the important decision is Rs 50 to be invested in equities,Rs 30 as real estate EMI,Rs 5 in commodities,including gold,Rs 10 in fixed income securities and Rs 5 in bank deposits. It is distinct from analysing and investing in individual stocks. Asset allocation is an optimisation equation based on two factors of personal goals and business cycle stage. Personal goals provide us time horizon,while business cycle stage facilitates an allocation decision based on present valuation ratios. For example,if equities are overvalued,allocation will be correspondingly less. Similarly,a short-term goal will require allocation to liquid funds and zero to equities and real estate. Asset allocation is dynamic,and changes as personal goals are achieved or change. It also changes as the business cycle stage changes with corresponding change in asset valuation. For comparison,if we are chasing a total of 300 in 50 overs,and if get a good start with 250 for 2 in 30 overs,we have almost won the match and should take very few risks. Similarly in wealth management,if we are close to a target,we should preserve profits or rebalance portfolio,since there is no point in toying with an already won match. Asset allocation helps make important exit decisions,based on simple valuation indicators and proximity of goal in time or targeted amount. Overall,just by implementing these two steps,the process becomes easier,timely,systematic and effective for harnessing the power of passive income and therefore achieving our financial goals. * The writer is founder,www.financedoctor.in
