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Why asset allocation of your portfolio is critical in achieving your financial goals

Posted by: Uma Shashikant on May 01, 2018, 06.30 AM IST

Why do we invest? We invest because we want our money to be available for a future use. We invest because we do not have an immediate use for that money. When we decide to call upon it to serve our need, we expect it to be available for use. In financial planning speak, being able to meet our financial goals is the primary objective of investing. How well we have done has to be measured only by that yardstick. 

Conversations about investing tend to get waylaid from this principle. It is due to the acute focus of the investment management industry on relative performance. Much of the information and dialogue are about who did better and how. The ability of a product to attract investors is woven around its performance, measured by return. It is well known that top performing funds attract significant amount of new inflows from eager investors. 

Mutual funds are run by investment managers and they showcase their performance. They choose a benchmark that represents a passive portfolio. They then measure themselves against this benchmark. If they do better, they generate an alpha, or excess return. They attribute the alpha to their investment management skills. But this is only half the story. 

Investors cannot live by relative returns. If the market falls by 10% and a fund by 8%, it technically outperforms the benchmark. The manager is right in claiming that the fund did better, but such performance would not mean much to an investor whose portfolio lost 8% anyway. Beating the benchmark is necessary but it’s not enough for the investor’s needs. 

Investors cannot seek absolute returns either. Years have been lost in the pursuit of assured returns and it is still a struggle to get investors to see that there is no assurance in the real world. Many investors want to believe that a professional investment manager is one who can promise and deliver a specific rate of return. In the risky real world, that is impossible to deliver. 

What happens to the investor’s core need of ensuring there is adequate money for financial goals? That objective is not met by investment performance alone. It has three primary components, each requires the investor’s active participation, deliberation, and sensible decision making. 

Financial goals are met primarily by the contribution the investor makes towards it. If the child’s college education is a goal, the parents will have to save with the understanding that a combination of money invested and the growth in value over time, will deliver the goal they seek. How this combination works is a function of how much they can save, for how long and how they invest those savings. 

Measuring the return alone will not help this goal. Such an exercise may become needlessly complex when contributions of various amounts are made at different points in time. How much investors will save, and how long they will let it be, is a function of their routine cash flows. Some investors settle for a government scheme like the PPF, arguing that an important goal like education should not be exposed to market risks. Some contribute, and then give up and then closer to the goal return to investing aggressively. There are no fixed rules, but each choice about amount invested, time it stays invested and the return on investment impact the final value. 

A financial planning exercise will help the investor set what the goal amount should be, based on reasonable assumptions about the cost, time and inflation. Then we juggle to invest and target the rate of return. Lower the return, lower the risk, but greater the amount the investor has to contribute. Seeking a higher return means the investment will contribute significantly to the final value, but the risk would be higher. 

This is why asset allocation is critical in portfolio construction. A portion of the portfolio chases returns and a portion protects from risk. Investors may not be able to achieve a perfect absolute return each year, but they can operate within a reasonable range. In a bad year when the return is lower, they can enhance their contribution as much as possible, and in a good year when the portfolio does exceedingly well, they can cut back and allow the investment return to roll. 

This dynamic management of end results is what investors primarily need, and it is not possible for producers of investment products to calibrate time, contribution and goal value for every investor and also manage to deliver returns that beat the benchmark. While mutual funds offer premixed products that hold equity and debt, or various assets in various combinations, they will still not be able to curate the investment experience for the actual contributions of the investor. That responsibility is that of the investor. Should they choose to work with a financial adviser, such professionals can help them manage their goals efficiently. 

The ideal adviser will focus on investors, their goals and investment strategy. They will navigate the investor through uncertain times and market behaviour and help them to stay the course. Markets for investment products are unfortunately dominated by producers who showcase performance and sellers who position such products. Financial advisory as a critical professional service needs much more advocacy, support and incentives. 

Investor participation in mutual funds and such financial products is low, because they hear and read primarily about product performance, tax concessions, rates of return. Their association is limited to transactions, and instances of disappointment are adequate to set them back. The focus on investment performance and rates of return is unlikely hold consistent investor interest as it does not align with their fundamental need for a fulfilling experience with investments. We have only come half the distance. 

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