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How to reduce your investment risks

Asset allocation is a difficult job that most people cannot get right. Here's why and how you should correct the flaws.

Asset allocation is not a wealth creation tool. It is a risk reduction tool, and has to be treated as such. I mean if you need Rs 1 crore as term insurance, and if you buy Rs 10 crore term insurance, you are not going to get richer. That is what I mean by making that statement.

Asset allocation is putting your money in 3-4-5 asset classes depending on your knowledge, and market access.

Assuming that you are an average middle class investor you have reasonable access to equity, bonds, real estate and gold. For purposes of argument we will assume that there is zero tax or the same rate of tax on return is applicable to all the asset classes.

So if you have Rs 100 you are told that you should have Rs 25 in each asset class.

In theory this is fine. So at the end of the year if your asset allocation has changed to 30 per cent in equity, 25 per cent in debt, 15 per cent in gold, and 30 per cent in RE, you should sell equity and RE and re-invest in gold.

This is how asset allocation is supposed to work. That is assuming you are a reasonable person wanting a reasonable return.

However in real life it is not very easy to do that.

Let us take an interesting example (not practical, but just as an example). Suppose you had the following asset allocation:

Rs 25 in equity shares of Hindalco, Rs 25 in debt of Hindalco, Rs 25 in aluminium and Rs 25 in land in Renukoot.

What happens when aluminium prices are low? Your portfolio is doomed.

So a good portfolio diversification has to be 25 per cent in BSE 500 fund, 25 per cent in an index bond fund, 25 per cent in a metal index fund, and 25 per cent in a RE fund with a diversified portfolio.

All the instruments should be ETFs (exchange traded funds), because that is the only way how you can ensure liquidity, ability to work with very small amounts of money -- especially for a switch, small transaction costs, etc.

Do not ask me whether I would recommend this. I will not. Simply because I deal with people who already have enough in debt instruments.

My asset allocation is very different. Here's how it goes...

Accumulation phase: debt for emergencies, enough RE to live and use (office?), rest in equities. Gold is an expense.

Consumption/Withdrawal phase: 1 year's expenses in liquid fund, 3 year's expenses in bond fund, next 2 year's expenses in longer term bond fund. Balance in equity. In fact I will be invested more than this in equity. Hope to meet my expenses from the dividends.

When you are 70 shift to equity index fund and index dynamic bond fund.

At age 75: Bank deposits, bond fund. Index fund. No direct equity. Unless one of the kids in the family is willing to take charge of my portfolio!