Investments are like saplings...you want them to grow into a tree to give you a shade. This simple example actually also indicates that making investments for wealth creation is a long-term process.
Just as the sapling can grow into a tree if it is fed regularly with water, wealth creation is a long-term process to be undertaken through a disciplined approach. I believe, ultimately, the investment process is an outcome of the asset allocation that one is needed to do to meet his financial goals.
So the critical component in the wealth creation process is the financial goal and not necessarily the age of the investor. The asset allocation is also said to be a function of the risk appetite of an investor.
While theoretically this may be true, it is very difficult to assess the risk appetite of a person...in a bullish market a person may actually indicate a higher risk appetite ...while if the cycle changes the same investors would indicate a lower risk appetite!! Finally what is known with certainty is the investment horizon as that is connected with some real life event and the current levels of income . Thus, I believe , it is the investment horizon and the income level, which should drive asset allocation to meet the financial goals.
One of the most important disciplines required for wealth creation is following asset allocation – allocating an investible amount across multiple assets classes. Asset allocation helps investors achieve income from fixed income investments and growth from equity investments. I do not consider mutual funds as an asset class as they are really a pass-through for investing in the underlying instruments.
Before determining asset allocation, one should appreciate that each asset class has a unique risk-return profile. For example, an equity asset class embodies a high risk – high return. It has a potential to generate higher return in long term; but in short term, it might be volatile.
This volatility / uncertainty is broadly referred to as risk in securities market. The uncertainty reduces with “time or investment horizon” , and so does the risk. On the other hand, investment in fixed income securities offer lower return and involves lower risk. As such, equity is suitable for long-term investment need and fixed income investment is suitable for short-term investment need.
One can have different types of financial goals to meet different kinds of needs in one’s life cycle. But the important point is each of this financial goal would have an investment horizon. Based on investment horizons different asset classes would be invested into to optimize the returns from investment .
The broad-brush approach may not work. Longer this time (irrespective of the age), higher should be the allocation to equity asset class. For example, I would advise a 30-year-old person who wants to buy a house 1 year down the line to invest his entire available savings in fixed income, and not in equity. By the same count, my advise to a 58 year old person, who wants to develop an “education fund kitty” for his 2-year old grand daughter, would be to invest significant part of the savings in equity.
It is equally significant to have a discipline to switch investments from equity to fixed income asset class, as the need for fund approaches . Remember, asset allocation is like a movie, not a still photograph. It needs periodical review and rebalancing.
The goal setting, as mentioned is critical for asset allocation . I know a case of an investor over 50 years of age who opted for a term insurance policy while funding for the foreign education of his son. Typically no one would be advised to go in for a term insurance at that age, but the financial goal made it probably necessary for that investor to look at the term insurance . Thus investors above the age of 50 also need to decide on their financial goals and then undertake asset allocation. Typically for investment horizons above 5 years even at the age of 50, equities could be considered as a predominant portion of assets. These equity investments should be ideally routed through the systematic investment plans (SIP) offered under various mutual fund schemes. It is “time in” the market, not “timing” the market that counts in the journey to wealth creation.
Thus investments made at the age of above 50 would also be dependent upon the asset allocation and hence the financial goal. In fact post 50 typically the investors would have a superior cash flow and actually have the next decade to build capital for comfortable retirement. Investors coming closer to retirement should consider lowering their risk exposure in the equities, as the dependence would be more on annuity kind of products.
However, with the steep fall in the returns offered by traditional products there would continue to be a need for products offering superior return on a tax adjusted basis to sustain the standard of living post retirement. Thus even post retirement there would be a need to have a small exposure to equities; in my view the monthly income plans offered by various mutual funds with a marginal exposure to equities could meet this requirement. It is the time horizon, not your age that should guide your asset allocation process.
‘‘ Tis Never too Early''
“We are young, we are free..... ”, this line from a song by the Moffatts is maybe the best way to describe the state of mind of a young executive in his 20s, who has just started working, has no responsibilities and is enjoying the new financial independence that a job brings.
“This young executive is thinking of ways to spend his first paycheck, and retirement planning is the last thing on his mind. The truth is that most people don’t think about retirement until it’s too late or they start to plan for their retirement when they are approaching it, which doesn’t help for sure.
Through this column, we are trying to influence the minds of the young and restless (young executives in their 20s), so that they can start their retirement planning early and aim to be financially free by the time they retire. This way they will be able to enjoy life in just the same fashion as they are doing today. Financial planners will tell you that just as it is very important to start early, it is also equally important to select the asset allocation depending on one’s age and risk appetite. Typically, a 20-year something will have a high disposable income assuming that he is unmarried, has no dependents and no assets that he is financing. This is the perfect situation to have a high exposure to equities, as the risk appetite is high and there are no long-term commitments to take care of. But since we are talking about retirement planning and assuming that the individual has a moderate risk appetite, this is what we propose based on our discussions with various financial planners. The young executive should start by looking at tax saving instruments as the lock-in periods in some are an ideal way to save for retirement. So go ahead and open a Public Provident Fund (PPF) and make maximum contributions to it. Since most executives will also have an employee provident fund (EPF), they can consider the combined limits as well. Now comes the time to look at equities.Since equity-linked saving schemes (ELSS) provide the dual advantage of tax saving along with marketlinked returns, our young executives can look at starting a small systematic investment plan (SIP) in any of the good ELSS so that a small amount is invested in the market every month. Medical insurance is another very important instrument that should be taken as soon as possible. This is because if there is no claim for 3-4 years, the probability of which is high given that one is still young, it helps in developing a good credit history. Young executives should also look at term insurance but they should not go in for a very high cover, as they don’t have any dependants. The cover can be increased after marriage accordingly. Personal Accident Cover is an important rider that should be taken along with the term cover, as it is never too early to plan for contingencies . This is also the age when one looks at buying small assets like a car or any vehicle. One should just ensure that too much salary does not get locked in paying EMIs as the outflows will increase with age or when one buys other assets like a house. While it may still be too early for most to think of buying a house, it is prudent to start saving for the down payment of the house, which will have to be made in a few years time.
While this may seem like the ideal mix of asset allocation for some to start planning for the future, there are some financial planners who don’t agree with the concept of investing in tax saving instruments at such an early age.
For instance, Devang Shah, a CFP certificate holder believes that if one has no dependents , then the entire saving should go into equities. He recommends the mutual fund route as according to him the 15-16 % tax-free annualised returns on a conservative basis are much better than the returns that any other tax saving instrument can offer.
We believe that there is no ideal way to allocate money for one’s retirement, but as long as one starts early and is prudent about the asset selection, the future looks bright.
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