In Praise of Polygamy

Unlike with choosing life partners, it’s best your money has many mates. Consorting with just that one asset class is pure idiocy.

Things that should get the highest priority are often the most neglected. Ever noticed this in life? So it is with financial planning. As the name suggests, financial planning should begin with ‘planning’, not trigger-happy action. We have already discussed the discipline of financial planning at some length in Go, Get a Map!, so let’s cut to a key question the planning exercise inevitably leads to: where should you channel your investible surpluses? In the world of finance, this exercise goes by ‘asset allocation’. In other words, how much of your investible wealth must you put into the different options your money has? Let’s understand this issue at two levels. One, why bother? Does asset allocation really matter? And two, if we agree it does, how to do it.

Dyed-in-the-wool equity fiends (I know the type, the quintessential Gujarati or Marwari baniya trader, who is always ‘into’ stocks and always has a view on where the markets are headed) will park all their money in stocks. The ultra-conservative (I know them too, the conservative TamBram Iyengar type) will rush to put all their annual savings in a Sundaram Finance (or State Bank of India) fixed deposit. Make no mistake: these guys are no role models.

It’s downright idiotic to do only one thing with all your money. Unlike choosing a life partner (the one for you), your money must never consort with just that one asset class. If this one thing were inherently risky (as stocks are), you’d end up hurting badly in a bad-market year. Conversely, if that one thing were the safety of government-guaranteed deposits such as PPF, you’d miss out on the opportunity of making supernormal returns from the stock market in a year like 2009. So, your money should never be wedded to just that one asset class; it must spread itself over a diverse bundle of asset types. That’s the essence of asset allocation.

Second, you might feel immortal when you’re young and find it hard to believe that your appetite for risk will wane as you age, but it happens. Your investing needs change over time. When you start out in your career, the new thrill of earning a steady income is matched by the urge to splurge on the good things you coveted in college but couldn’t have, or have them only by sponging off your dad. Now you have the means and you whip out your credit card in a blink. When you invest, you do it with the arrogance of youth, you take the silliest risks with your investible surpluses and, guess what, you mostly get away with it. Because age is on your side and over time your portfolio will have recovered from the early shocks. You can afford the aggression with which you seek to multiply your money.

As you age, and your family grows, your spending increases. But by now, all the space once reserved for wants has been overrun byneeds. You find yourself staring down a seemingly endless spending pipe: years and years of increasing expenses. It’s then that prudence enters your life, and you start think seriously of saving for your goals. You are not cavalier with your investments any more, you now take calculated risks because you figure that bad investment decisions now might make irreparable dents in your portfolio. And you wonder how much investment risk is just enough, yet not too much. Here’s my rule of thumb for you: subtract your age from 70 to get (in percentage terms) the fraction of your kitty that should be in high-risk equity. If you’re a naturally aggressive investor, you can jack that up to 80 or even 90.

So if you are twenty-five and an aggressive risk-taker, you can coolly put 45-55 per cent of your wealth pile into equity. Also, even if you have the time—and the ability, not just a ‘feel for stocks’—you should personally manage no more than 50 per cent of your equity portfolio. The rest should be managed professionally. People with a tab of over Rs 25 lakh have wealth management options such as PMS (portfolio management services); the others can access equities via mutual funds, where you can invest as little as Rs 5,000.

The difference between a mutual fund and a PMS provider is notional, much like it is with a bus and a taxi. Both take you more or less where you want to go, but you feel a little better taking a taxi because it’s working exclusively for you. So you pay a little more for portfolio management services, and get a little more pampered. Since the PMS management style is not a preset, be prepared for some unexpectedly good (and sometimes bad) luck along the way. Mutual fund portfolios, on the other hand, are more diversified and though they are safer, they’ll often struggle to outperform the broad index returns over a period of time. Disclaimer: there are some pretty decent and honourable exceptions.

Which brings me to a very important point. Why should you bother to pay a mutual fund something like 2 per cent (and more in the case of PMS) per annum if you are happy with ‘index’ returns? In the long run, we’re told that equities outperform almost all asset classes. Compounded over a ten- or 20-year period, the extra money management fees that you pay a diversified mutual fund versus what you would pay a ‘passive’ index-tracking fund will add up to a significant amount. I think young people with a healthy appetite for risk should ideally lock regular bits of their savings ‘passively’ into equity via index funds, which charge much lower fees. Over a long time, this can do wonders to your wealth.

What can be ruinous to your wealth or financial well-being is to be underinsured. Insurance is a bit like marriage, your father did it and so did his dad. But you are not sure whether it makes sense for you. At its simplest, insurance is like protection against unknowns. The simple lowdown on insurance is that you must protect what is really worth protecting. So if your partner is not working, there’s no compelling need to insure her life because there’s no potential loss of income (there are other irreparable losses, of course) on her death.

On the other hand, the life of the family’s primary breadwinner must be insured for at least five or even ten years worth of annual income. Contrary to popular belief, insurance is desperately needed when you are young and newly employed, because the potential financial loss on your death is that much more. As you grow older, you have fewer years to go in your career, so it’s best to buy a heavy term plan (say 5x five-year future annual income) as soon as you start working (also, this is when a term plan is cheapest for you). Life insurance is considerably cheaper for the young, and remains relatively cheap for the already insured as they age. Don’t worry if a disproportionate part of your savings is getting into insurance. Chances are you will earn more as you age, so this fraction will come down gradually as you save more.

For first-time buyers of insurance, a term plan finds least favour because it is insurance at its purest: you don’t get back any of the premium unless, god forbid, the insured event happens. Sadly, insurance agents also don’t hard-sell term plans as they provide the lowest commissions. But term insurance is by far the cheapest way to manage life risk, without getting obliged to put aside parallel investment allocations every year. This is what unit-linked insurance plans (ULIPs) and endowment plans do. I am personally against ULIPs (they combine insurance and equity investment) because by and large they seem to lack flexibility. Again there are some excellent exceptions to this general rule.

With the rest of your money, the choice boils down to debt, insurance, bullion, real estate and some exotics like art, currency and suchlike. For now, let’s leave out the exotica and focus on the more common stuff.. With real estate, the best option is to allocate a sum that will not be required for a long time (say, a decade or more). With such a time horizon, decent positive returns are close to assured, as the experience of our parents and grandparents indicates. The modern-day investor has the option of buying into real estate funds as well, so that you can invest in parts without running into the problem of spending a large lumpsum at one go.Finally, bullion (or more specifically, gold) is the ultimate Indian hedge against inflation and calamities. With governments around the world resorting to printing money recklessly, it is said that inflation will become unmanageable, and that gold will skyrocket. This makes sense, except that even if it were to pan out this way, you would not get linear movement. So, as in real estate, be prepared to wait it out for a really long time (a decade at least) to be sure of earning appreciable returns on your investments in gold. Also, remember that holding gold in the form of jewellery will always lead to some erosion in ‘gold value’ you derive from it.

Given that bullion and real estate typically yield good returns only over long hauls, it’s best you progressively tune down the allocations to these asset classes as you grow older. Of course, if you’re living in a house you own, you cannot monetise it (unless you’re comfortable using something called ‘reverse mortgage’, but more of that some other time). As you scale down your bullion and real estate investments in your old age, it’s best you divert them to debt. This works best for retired people as they need the fixed, regular income debt instruments provide.

Net net, start early in the investing and asset allocation game. Funnel more of your money into equity and term insurance in your early years. Review your asset allocation once a year, or at least once every two years. As you earn and (hopefully) save more, you will find that bullion and real estate open up new diversification possibilities. As you age, gradually exit your equity portfolio and divert it to debt. Finally, do the same for bullion and real estate. Throw in reverse mortgage for late-life indulgences. As my favourite wealth manager says: invest well, celebrate life!

The author is Vice President (Institutional Sales) at BRICS Securities. The views expressed here are his own.

asset allocationinvestmentpersonal finance