Yesterday I wrote about continuing with your Systematic Investment Plans if you have your job and avoind encashing your investments.
My wife and I were discussing on our own situation given that the market has gone down substantially and she was bothered her own investments would be totally messed up.
That’s when I explained to her the philosophy of Asset Allocation and why she need not be so worried about her investments.
While you will see that most of the articles I write are about investments in some form of equity where you own part of business, especially if don’t have one of your own. However I have mentioned this earlier and I will mention again that the way to financial freedom has to do with an asset allocation based on your risk profile.
In simple terms asset allocation is distribution of your investments in such a way that irrespective of the direction the equity markets take or the interest rates take you have your principal amount protected and growing at a steady state. In the picture above if the lady in the picture happens to see a dog come at her suddenly and drops the basket, all her eggs will break and all her effort in building her dish would get destroyed
So if you have $100 to invest and you have put all the money in equity, while in the long run it may give you around 12% or so, in the short run – like it happened in the last 3 months – it would have gone negative by more than 30%. By putting some of your $100 in term deposits of even 5% you would have ensured that your overall hit was averaged better. Its all about ensuring that “all your eggs are not in the same basket”.
No doubt that equity gives the nest returns in the long run and is also the most tax efficient in most countries, however not everyone has the risk profile to do the roller coaster ride that the equity markets go through. This would be true whether you have invested directly in stock yourself or if you have invested via ETFs or mutual funds. With mutual funds and ETFs the ride down could be less severe while the rise upwards could also be slower.
Its always better to have some amount of allocation of your money in debt like in term deposits or bonds. How much can better be judged by your personal financial advisor but have some portion of your total investments in some kind of debt. Fixed term bonds or deposits will ensure that you get a fixed return on the money invested irrespective of the situation in the equity markets. Even though the returns will be lower, an it may not be so tax efficient, the fact that it is a guaranteed amount makes your portfolio a lot more resilient.
There is a very good explanation on Asset Management in the book Money Master the Game by Tony Robbins. He has interviewed multiple fund managers on how they do the fund management of billions of dollars. Some of them also invest in things like commodities and precious metals and real estate. So its always better to consult a financial advisor before deciding on the type of asset allocation you want to do and the risk profile you have.
Yes bond markets also go through tough times and the bank, in which you had your term deposit, can also shut down, but the probability that all the things will go wrong at the same time is remote. Hence the concept of asset allocation becomes even more critical.
Government owned securities obviously are the most secure but they give the lowest interest, then come the bank term deposits and the highest would be the bonds in terms of interest rates. However as the interest rates climb, the risk also goes up.
Spread your risk by consulting with your financial advisor and move towrds your financial independence.
Till next time.