(Originally published in MoneyControl.com)

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After co-authoring the last article “Cutting your portfolio to size”, I was taking a much un-deserved rest on a lazy Sunday noon, when my friend called me up, rather woke me up! His question was should I invest in Xyz Company’s shares or invest in a safe FD since the markets look high? He was, like many investors thinking that investments are isolated, sporadic activity that you do when you have some spare cash or when you want to imitate or impress your relatives and friends.

While it is fine to impress your brother in law with a swanky Swiss watch or a latest gizmo, it may not be the right approach when it comes to investing.

I told him that first we need to see what his asset allocation was before deciding where we should invest. After all you don’t tell the doctor to prescribe medicines before you even tell him what is your ailment or what other medicines you are taking currently.

So in this article let us see what Asset Allocation means and why is it important.

In simple terms, the idea of asset allocation is to balance between risk and reward by investing across asset classes based on how long you would stay invested and what risk can you take.  The idea is to be exposed to all asset classes and not take too much or too little risk.

Asset allocation is about finding an optimum solution between extremes. There are investors who tend too much in one or other direction – either don’t invest in stocks at all, or go to the extreme of borrowing money to invest in the stock market. Clearly, either approach is incorrect and could lead to an imbalanced portfolio. The right approach is to have an exposure in different asset classes in a manner that, overall, the risk/return ratio is optimal for the investor.

Asset classes

The three broad asset classes are equity, debt and cash. Apart from these there is also an asset class of real estate, gold etc but let us keep that aside now and look at it another lazy Sunday.

Cash needs no explanation - it is simply money in the bank for a rainy day,

Debt investments can be further divided in two: 1. What I call sacred assets - such as traditional investments: Bank fixed deposits, PPF, and Post office schemes. Why call them sacred? Well, that’s because they are at the foundation of the portfolio, providing steady, risk free returns that grow steadily. They provide for solid safety during tough times. Its’ nice to know that this money is very safe and can be accessed in testing times.

Then the serious assets ranging from highly rated corporate deposits (which are rated but not guaranteed) to debt or income mutual funds which can potentially give more returns but are prone to volatility in interest rates and do not carry any guarantee on either the principal or returns. They are suited for those who want more returns but can afford to take some risk.

And then there is the riskiest of asset classes, equities, love them or hate them you just cannot have a portfolio without them.

Equity ranges from investing in equity shares of listed companies or simply investing in an equity mutual fund that can get you a well-diversified portfolio.

There are asset allocation funds that can invest in a mix of assets too.

How to decide?

So now, what is the right allocation for you? How much in equity, debt or cash? The answer is in your hands. No, I don’t mean you have to consult a palmist to arrive at the answer.

There are no magic secrets to allocate assets between the three but a good idea is to have higher allocation to equity when one is young, and keep reducing as we grow older and can’t take too much risks. Asset allocation is one of the most important decisions that an investor makes and should be done after finding out two important factors that influence it:

1. How long can you stay invested? The longer the time frame, the more your portfolio should have a bias towards equity. If you have a time frame of ten years, equities would be a better bet than deposits or other debt instruments. If on the other hand, you need the money in six months, a short-term deposit is the best option.

2. What’s your risk tolerance? Are you conservative, moderate or aggressive when it comes to risk-taking? One thing to remember, however, is that people view the notion of risk differently in different spheres of life. That is because the way people view money is almost always different from how they view other things. A professional stuntman, for example, could very well be a very conservative investor, keeping his cash in between his cushions. A demure salesman might be playing with his money in the commodities market like there is no tomorrow. So, identifying one’s risk tolerance when it comes to investing is a specific task in itself, and could be a surprising revelation to the investors themselves.

There are some useful risk profiling systems on the internet that ask smart, relevant questions about how you view money to identify what kind of risk taker you are. An Internet search of “investment risk profiler” yields a handful of such tools that can be very helpful.

Once you know the answer, then selecting whether to invest in equity, debt or cash becomes easy. This top down approach inculcates discipline while taking investment decisions so that we make our hard earned work hard for us in turn. All investments are to be fitted into a larger canvas of your overall asset allocation, so that you can see whether you are taking more risk or less.

So what was my answer to the question on whether to invest in the stock or FD? The answer is whichever fits into the overall asset allocation that fits the investor’s time frame and risk profile. In this particular case, it turned out that friend had a widespread investment in various equity schemes – mostly large cap, some sectoral funds. So, I told him to place his latest found money in either a short-term debt fund (HDFC high-interest fund or DWS Money Plus fund are fine examples) or a highly rated corporate fixed deposit (HDFC, Sundaram Home finance are good choices).

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