Asset allocation is one of the most important factors that determine overall portfolio returns. Research indicates that 90% of the portfolio returns can be attributed to asset allocation. Yet asset allocation is one of the most ignored aspects of financial planning for most retail investors in India. In this article, we will discuss some common asset allocation mistakes that investors should avoid.
No Goal Planning: Many investors save and invest in an undisciplined way. Some investors want to invest because their friends are investing in mutual funds or stocks. There are others who want to invest in equity because the market rose by nearly 40% last year. There are some who have excess funds that they do not know where to deploy and want to evaluate options like fixed deposits, mutual funds etc. Lack of clarity on the objectives causes investors to make the wrong investment decisions. Unless you have financial goals and time horizon clearly defined, you cannot determine your optimal asset allocation.
Not investing or under investing in desired assets: Not investing in the desired asset classes in the right proportion will result in sub-optimal returns from your portfolio. Allocating a sub-optimal portion of the investment portfolio to equity is a common mistake most retail investors make. Investors must factor in the impact of inflation and taxes in their investment planning. There are several broad asset allocation guidelines that can help investors determine suitable asset allocation for their individual needs. We have discussed some of these in our article, Asset Allocation strategies for different age groups. Investors should also note that while asset allocation is commonly used to refer to the allocation between debt and equity, it also includes other asset classes like real estate, gold, cash etc. One should consider all these asset classes, when determining their asset allocation.
Short term focus: While for most investors the more important goals are long term in nature, most investors have preference for assured return products. This reflects a short term focus, which in the long run can leave investors short of their financial goals. While we prefer risk free high assured returns, investors should understand that there is no such thing as assured returns in the long term. Let us take the case of risk free fixed return products in India. 15 – 20 years back risk free assured return products were giving returns, as high as 14 – 15%. Now, it is almost impossible to find any risk free fixed return product that will give anything higher than 9% pre-tax return. Extreme risk aversion also makes investors oblivious to factors like inflation and taxes that negatively affect their risk free returns. A chartered accountant friend recently told me that most of his clients in the highest tax bracket get the shock of their lives, when they are told that they have to pay a large amount of tax on their fixed deposit interest, even after the 10% tax deduction at source. The truth is that taxability of fixed deposit interest is nothing new. We are either uninformed or deliberately choose to ignore it because of our short term focus.
Unrealistic return expectations: Unrealistic return expectation is another common mistake in asset allocation and this often leads investors compromising on their financial objectives. Lack of awareness is a root cause. Just because a stock price doubled in a year, it does not mean that it will double next year also. Some mutual funds gave 70% returns in the last one year, but expecting them to give 70% returns this year is unrealistic. Real estate is one asset class, where investors often have unrealistic expectations and this leads them to make the wrong investment decisions. While lot of real estate investors made very handsome returns, there are lot of investors who have lost and are still losing money on their real estate investment. Possession delays, interest cost, market dynamics, litigations and infrastructure delays can have a huge impact on real estate investment. From being one of the most favoured investment sectors in the hey days of the 2007 bull market, real estate has now become one of the most unfavoured sector. The stock prices of real estate companies are just reflections of the underlying problems the sector faces. I am not saying real estate will not be a good investment. But one needs to make a well researched investment decision with the appropriate time horizon. In order to determine an optimal asset allocation, you need to have realistic return expectations.
Changing asset allocation too often: Changing asset allocation based on market conditions is another common mistake many investors tend to make. One of the basic tenets of equity investing is buy low and sell high. Retail investors often tend to do the opposite. Investors sell their equity mutual fund units or stop their SIPs in a bear market. Whether it is to prevent further losses or waiting for the market to correct further, investors should note that it is almost impossible to time the market. I know of investors who exited the market in 2008 and shifted to fixed income, invested again in equities when the market was 3.5 times higher than the 2008 lows. On the other hand investors, who continued their SIPs throughout the bear market and into the bull market created wealth. There are some investors who shift their asset allocation, when some other asset classes catch their fancy. I know investors who shifted from equity to gold, when gold was rallying. Now, while gold is giving negative returns over the last 2 years, they are regretting that, they did not get into equities at the right time. I know other investors, who sold their mutual funds to buy multiple properties because their friends or relatives bought in some hot projects. Many of these properties did not take off as anticipated and now these investors are complaining that they have been left with these illiquid assets while having to service the home loan debt at a high cost. Asset allocation comprises the right mix of equity, debt, gold, real estate and cash. One should ensure that they maintain the proper mix so that they can get consistent returns.
Not changing asset allocation at all: While changing asset allocation too often is a mistake, not changing it at all is also a mistake, especially if you are nearing your financial goals. A friend and colleague, a few years older than me, wanted to take an early retirement from his job in 2010 and start an organic farm. He started planning for it from 2000 onwards and based on the guidance of an excellent financial advisor had the right mix of investments. By 2007 he was well on track towards his retirement goal and plan of starting an organic farm. Unfortunately in 2008, his investments, which were heavily in equities, lost nearly 50% of in value. His employee stock options, which he was hoping to exercise to invest in his farm, was 30% below the strike price and was worthless. What was worse that, he lost all confidence and made several wrong investment decisions after that. Today he is still working in the same company where he was working before. He is bitter about what happened in 2008, but much wiser. His plan of early retirement definitely had a setback, but he still plans to retire in the next 5 years. Over the last 3 years he has started investing in equities again, only this time he plans to shift his investments systematically to income funds through systematic transfer plans (STP) two to three years before his planned retirement. It is important that you shift your asset allocation to less risky assets when you near your financial goals.
In this article, we have discussed some common asset allocation mistakes that investors should avoid. You should educate yourself about appropriate asset allocation that is consistent with your risk profile. You should also educate yourself about the various factors impacting the returns of your assets. It is always prudent to seek the guidance of an experienced financial advisor to make sure that you are on course towards your financial goals.