Become a smart investor

Asset allocation is the key for determining an investment strategy that aims at balancing risk and reward by apportioning funds across different asset classes. Amount of investment in a particular asset class is guided by multiple parameters like investment horizon,returns expectations and risk tolerance. Usually lesser number of responsibilities tend to make younger investors a lot more aggressive and tolerant towards risk compared with individuals that are closer to their retirement age or probably investors who are in their middle age and are bounded by other financial obligations or have a family to support.

Asset allocation is strategic and long term in nature and eliminates the need for day-to-day decisions involved in investing. However,this strategy needs to be monitored,reviewed and rebalanced to ensure that the investments are in line with the objectives.

It is important to review your investment portfolio once or twice in a year to keep a check on the progress made and correct any deviations. This needs to be done in consultation with some financial sector expert such as a relationship manager or a financial advisor,who provides inputs to determine the best way to allocate assets in various financial instruments.

A typical asset allocation strategy would comprise of various asset classes comprising fixed income,equity,real estate,insurance,commodities and alternate investments.

Fixed income

Fixed income investments provide stability as well as liquidity to the portfolio. Fixed income encompasses traditional products like bank fixed deposits,Public Provident Fund (PPF),National Savings Certificate (NSC),Kisan Vikas Patra (KVP) and bonds of various maturities issued by Government and corporate institutions. While these instruments do lend the safety of capital,returns generated by them are far less than the prevailing rate of inflation. Therefore,in effect,they generate negative real rate of return.

Equity

Allocation to equities is a must. It has been proved that over a longer time horizon equity as an asset class outperforms other asset classes. Since its inception benchmark BSE Sensex has a compounded annual growth rate (CAGR) of 18.1 per cent (excluding dividends),which is significantly higher than returns on fixed income investments. The calculation is made taking into account performance of this index during last 31 years till March 2010

There have been periods when the returns have been much higher. If we analyse the last bull run,BSE Sensex had given an annualised return of 35.4 per cent between March 2003 and March 2008. The run up were backed by earnings CAGR of 31 per cent over the same period.

Now that the global financial crisis has abated,the Indian economy is expected to get back to its growth trajectory of around 9 per cent in the medium term. Sensex earnings are expected to grow at a CAGR of around 15 per cent between FY2010 and FY2013. Equity returns should be broadly in line with earnings growth over the same period. Equity investments can be in the form of mutual funds,direct equities and exchange traded funds (ETF).

Mutual Funds should definitely be a part of the portfolio as they help in spreading risk across different sectors and then within each sector they further allocate among several companies after thorough due diligence and research. Being professionals,the investment options with MFs are also quite vast with regards to the risk profile,time horizon and return expectations of clients. Investors can choose between a conservative and an aggressive fund across small,medium and large cap funds.

The best way to invest into direct equities is through a systematic investment plan (SIP) offered by mutual funds. This is by far the most disciplined approach towards regular investments and contributes towards long-term objectives. The fundamental of long-term horizon, which is extremely important for equities is taken care of through this route.

Real Estate

Real estate investments can be either in the form of physical asset or through investment vehicles like private equity or Real Estate Investment Trust (REIT). REITs,however,are yet to make a debut in India. Real estate can be for self consumption or for investment purposes. Real estate investments generate regular cash flow stream in the form of rentals while providing upsides through capital appreciation.

Commodities

Commodities are an important part of any asset allocation strategy as they provide hedge against inflation. Commodities include both industrial as well as precious metals. Globally,the most preferred method of investment in commodities is through ETFs. In the Indian context,gold ETFs are available and are traded on the exchange.

Alternate Investments

While traditional investments continue to be the preferred investment vehicles,alternate investments are a relatively new concept in India but are worth looking into. Alternate investments encompass a wide gamut of products including art,stamps,wine and offshore investments. While it is recommended that traditional investments should constitute a large part of allocation alternate investments can be used prudently for diversification.

Model Portfolio

A model portfolio helps in determining the clients place in the range of aggressive to conservative investors,based on the risk tolerance,investment objectives and timeline. Each model portfolio reflects a possible combination of various asset classes for a representative investor profile.

The Model portfolios have been designed keeping in mind key factors like:

* Time horizon

* Risk appetite

* Returns expected

* Indices to which they are benchmarked

* Volatility of the underlying asset classes

The universal objective of any investor should be to reap maximum outperformance or excessive returns over the broader market returns while getting exposed to minimum possible risk within the set time frame of investments.

Model portfolio enables investors to professionally manage their investments to achieve consistent capital appreciation with minimum possible volatility. Professional analysis and portfolio composition takes an objective view across asset classes and avoids personal bias.

The writer is CEO and managing director at the Fullerton Securities