130 Financial Planning Handbook PDP

Chapter 19
131 Financial Planning Handbook PDP
Growing your Net Worth
Are you lucky?
L
et me draw out an important and a relevant scenario for you. Read on as we discuss an important
issue. Most of us who have bought a house, should consider ourselves lucky. Why?
The double whammy of rising real estate prices and increasing interest rates is threatening to put homes
out of reach of most first time buyers. Heres the worrying statistic, brought out by HDFC- in 2004, the
average home owner could buy a house at a price that was equal to 4.4 years of his annual income.
Today that figure has been pushed to 5.1 times, meaning that he will need more than five years income
to buy the same house despite an increase in his own income during the intervening period.
EMIs
Even worse, the equated monthly installment (EMI) that hes required to pay has shot up from 42% of the
monthly income to more than 67%. More than the rising prices, it is the hike in EMIs that could end up
making homes unaffordable. In 1995, almost 35% of the home loan applicants to HDFC had an annual
income of around Rs. 1.2 Lakhs. Since most of the people who came from that bracket, thats the figure
that was assumed to be the homebuyers income. Coming to the 2000s, the average salary increase
from 1995 to 2007 amounted to 13.2% annually based on data across a cross section of industries.
Infact the year 2004, was the best year to buy a house, since the price to income multiple touched a
lowest of 4.4 and EMI as a percentage of the income, touched a record low of 42%.
Then the tide began to change. Home prices rose faster than incomes and the interest rates have shot up
faster. The latter is worrying since the banks usually ensure that the EMIs does not exceed 40% of the
borrowers monthly income. Under exceptional cases, it can go up to 50%.
In a scenario today, where the EMIs have gone up to 67% of the monthly income, the banks will simply
not loan enough money to make the purchase. To make the EMIs more reasonable, the prospective
buyer will have to pay more than 30% of the cost of the house on his own. But bankers also mention that
young people dont have that kind of money saved up.
So we notice that the gap is widening.
Speaking of asset classes, real estate in terms of buying a home for occupancy is the single most
important agenda in a persons lifetime. It is not for nothing that they say that buying a house and
marrying off a daughter well, are the two primemost concerns of a father. So plan ahead of time.
A house is only one asset class. There are many others. The wide range of investment options available
today also makes for a difficult, yet important investment decision. Terms like fixed deposits, bonds,
debentures, stocks, mutual funds etc, present a complicated puzzle, which a layman finds difficult to
understand. It is extremely difficult to identify a single investment that will perform well in a particular
year. Given this difficulty, investing in just one securityor one type of security is risky. Therefore,
putting all your eggs (money) in just one basket (investment) may result in a large gain or a large loss.
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It is here that the importance of asset allocation really emerges. Simply put, asset allocation, as the
name suggests, involves determining the right balance or mix of your investments into various categories
called asset classes or vehicles. Asset allocation is probably the most important decision and may
account for more than 90 % of the return of the portfolio.
What are asset classes?
Broadly speaking, the main investment categories (also known as asset classes) are the following:
Stocks
These are one of the riskier asset classes and represent an ownership or equity position in a corporation.
A stockholder can lay claim to a proportionate share in the corporations assets and profits and is
often paid dividends when the company makes money. Stock share prices will rise as the corporation
grows and there is greater demand for its stocks.
The idea is to buy stock when the company is still small, hold onto it for a number of years while the
company grows and becomes financially stronger. Then, sell it for a profit once the stock price has
risen as a result of new demand.
Bonds
A bond is a debt instrument issued for a period of one year or more.
This is a more conservative investment.
Bonds raise capital for the issuer by borrowing money from investors. With a bond note, the issuer is
basically promising to repay the principal along with interest on a specified date, also known as the
maturity date.
The government, states, cities, corporations and many other types of institutions sell bonds.
Mutual Funds
This is managed by an investment company that invests money belonging to a large number of
shareholders in various assets.
The primary advantage to investing in a mutual fund is that you automatically achieve a diversified
portfolio that is managed by professionals whose advice and expertise you might not otherwise be
able to afford.
Cash Equivalents
Cash equivalents are safe, short-term, very liquid investments that are, as the name suggests,
equivalents to cash.
Cash equivalents are excellent savings vehicles for short-term goals.
Real Estate
This may be defined as land and anything permanently fixed to it, including buildings, sheds, and other
items attached to the structure.
Unlike other investments, real estate is dramatically affected by the condition of the immediate area
where the property is located. With the exception of a global recession, real estate is affected
primarily by local factors.
The downside is that more time to sustain this investment is required. The maintenance and
management of the property will fall on the owners shoulders.
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Commodities
In India, commodities as an asset class has delivered strong returns in the last two years with prices of
commodities across segments bullion, metals, agricultural products, crude, chemicals at multi-year highs.
Commodities generally outperform other asset classes in an expansionary phase and deliver extra-
ordinary returns within short periods.
Commodities exhibit low correlation to equity and fixed income instruments and, therefore, provide a
natural hedge to the portfolio. Commodities, thus, provide a balancing and sobering effect on the
portfolio.
The outlook for commodities is positive given that the uptrend in the demand for a wide range of
commodities, driven by the high industrial growth in China and India, is likely to continue after having
spoken of different asset classes.
Comparison between two different asset classes
Let us consider the trend to see how the returns from sensex have performed against the various metals,
leading to a discussion on the importance of broadening of ones portfolio.
Consider the last one and half years. If you compare the rally between the period of 6th February, 2006
and 6th July, 2007, this period saw the benchmark sensex moving up from 10000 to 15000 mark. The
average return from an equity investment was around 50% while the return from the precious metals like
gold and silver was as little as 4.5% and close to 25% respectively.
Bright prospects of the overall Indian growth story, coupled with comfortable liquidity flow make the
equity markets soar, while a lull in the demand of precious metals has given investors lesser returns in
other asset classes. Besides the rupees appreciation has also spoiled the party for gold investors in the
bullion market. Investors in both the metals have not realized the gain due to the rupees rise. Large and
small traders are equally shying away from piling up the stock, fearing further losses in case the strong
rupee rally continues.
In the international market, the investment inflows into gold have slowed down in the last 6 months. This
leads one to understand that a person should always invest in different asset classes and broaden the
portfolio, so that not all the eggs are put in one basket.
An investment in the real estate market, on an average in the equivalent time period, though it is too
short to make a judgment call on real estate investment for less than 10 year periods, have shown a
return of 20%.
To conclude the equity market has given the largest returns.
Comparison of returns between the different sectors in one asset class - STOCKS
We move to the next step of details. We are now getting into the analysis of equity returns sector wise.
The reason for bringing this discussion here is that this kind of analysis will become common everyday
parlance for a financial planner. This is also the language of money channel-CNBC. It will become
ASSET(Sensex vs. heavy metals) 6 FEB06 TODAY 6 JULY07 RETURN %
Sensex 10000 15000 50
Gold 8208 8582 4.56
Silver 13721 17150 24.99
Aluminium 115.5 111.9 - 3.12
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important and relevant while making presentations and having discussions with the clients.The financial
planner will know how the returns can be mapped with the markets and it will be an enriching experience
for him to know more about the returns from different instruments available .Now we can analyze the
sectoral changes in the equity market in the last one year. You can also see how the % growth of return
from the individual sectors has slowed down in the past one year.
If you see the growth between early 2004 and mid-2006 was mainly because of re-rating of India as an
emerging market. This meant that there was a strong rally across all the sectors. Now the last one-year
has seen that the re-rating phenomenon has passed, and the growth is more specific to certain sectors.
Some of the sectors like the FMCG were undervalued at that time and thus returned 194% in this two-
year period. However, with the major correction in May-June06, the sector has been lagging far behind.
IT, Oil and sun-rise sectors like media and telecom have performed better, while the rest have witnessed
poorer returns than the benchmark, and returned lesser than the May06 levels.
Based on the above mentioned discussions, let us look at Neerajs example correlating it to the two
different tables shown above.
If Neeraj had invested in the metals sector in 2006 an amount of Rs. 50000, and stuck on to it, he would
be at a loss today, after 1.5 years, which comes to a negative of 13% on Rs. 50000 ie. Rs.6500. This is
called an aggressive approach to investing.
While if the same amount, Rs. 50000 had been invested in an fixed deposit, he would have earned an
interest of 12% cumulative, at 8% pa rate of return. Neeraj would have earned Rs.6000.This is a
conservative approach to investing
Ideally, if he had invested 50% of his total money, ie Rs. 25000 in Fixed Deposit (FDs) and the rest of the
25% into two different stocks in two different industries each, lets us see how his investment works out
for him.
Lets say, he had invested Rs. 12500 in technology stocks, and the other Rs. 12500 in metal stocks . The
overall portfolio of Rs 50000 would now be divided into 3 different investments. His FDs at 12% would
have given him, on Rs. 25000 ie. Rs. 3000. The 12500 in Aluminium based metal company would have
yielded of negative of 13%, which is a loss of Rs. 1625. The rest of the investment of Rs. 12500 in an IT
company would have yielded him at profit of 50%, ie 6250. So his overall income would have been Rs.
7625. This is definitely a better return than both a profit of Rs. 6000, or a loss of 6500.
SECTORS MAY06-APRIL07 (%) AUG04-MAY06 (%)
TECH 49.56 187.33
INFOTECH 26.66 162.69
OIL AND GAS 19.05 121.34
SENSEX 12.05 150.56
CAPITAL GOODS 9.46 304.96
HEALTHCARE -1.19 94.11
METALS -12.91 207.05
AUTO -13.96 208.04
FMCG -17.88 194.37
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As a general rule, asset classes, give different rates of return over different periods of time. To run
through the troughs and the peaks, we can use a conservative yet a smart approach methodology called
asset allocation, as Neeraj finally understood the hard way.
What is the basic idea behind asset allocation?
The main idea behind asset allocation is that you can balance risk and return in your portfolio by spreading
your investment amount among different types of assets, such as stocks, bonds, and cash equivalents.
This is how it works:
Different types of assets carry different levels of risk and potential for return, and typically dont
respond to market forces in the same way at the same time.
When the return of one asset type is declining, the return of another may be growing (though there
are no guarantees).
If you diversify by owning a variety of assets, a downturn in a single holding wont necessarily spell
disaster for your entire portfolio.
Asset Allocation means Diversification of Risk
In the 1950s, Nobel Laureate Harry Markowitz revolutionized the financial markets by showing that
owning a diversified portfolio of stocks could lead to higher returns with less risk than owning any individual
stock. Since then, it has been a commonly accepted fact that Asset allocation is a way to control risk in
your portfolio. The risk is controlled because different asset classes in a well-balanced portfolio will react
differently to changes in market conditions such as inflation, rising or falling interest rates, market
sectors coming into or falling out of favor, a recession, etc. The following are the benefits diversification
of risk or asset allocation:
Diversification across asset classes balances investments with higher levels of safety with those
that have higher levels of growth.
Spreading a portfolios investment risk across several types of investments can help smooth out the
ups and downs of investing.
There are different asset classes like equities, bonds, real estate, cash and even foreign investments (to
a limited extent) available to Resident Indian investors now. It has been a well established fact that
Asset allocation has been primarily responsible for portfolio performance more than even stock selection
and timing issues. Asset allocation is the key to portfolio returns and hence, it is of paramount importance.
An asset allocation decision involves deciding the percentage of investable funds to be placed in stocks,
bonds and cash equivalents. It is the most important investment decision made by investors because it
is the basic determinant of the return and risk taken. This is a result of holding a well-diversified portfolio,
which we know is the primary lesson of portfolio management.
Thus, asset allocation serves the purpose of diversification among different asset classes and
diversification among different securities within an asset class.
The returns of a well-diversified portfolio within a given asset class are highly correlated with the returns
of the asset class itself. In other words, the returns on a stock portfolio will depend on the market returns
to a great extent. No stock is expected to give phenomenal returns when the market returns are low or
negative. Within an asset class, diversified portfolios will tend to produce similar returns over time.
However, different asset classes are likely to produce results that are quite dissimilar. Therefore, differences
in asset allocation will be the key factor, over time, causing differences in portfolio performance.
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Factors to consider in making the asset allocation decision include the investors return requirements
(current income versus future income), the investors risk tolerance, and the time horizon. This is done in
conjunction with the investment managers expectations about the capital markets and about individual
assets.
According to some analysis, asset allocation is closely related to the age of an investor. This involves
the so-called life-cycle theory of asset allocation. This makes intuitive sense because the needs and
financial positions of workers in their 50s should differ, on average, from those who are starting out in
their 20s. According to the life-cycle theory, for example, as individuals approach retirement, they become
more risk averse and hence, they should allocate fewer amounts in percentage terms to equity and
equity related instruments in their portfolio.
Asset Class Risk
Risk in the context of investments has different meanings for different people. To the common investor,
risk means the probability that he may lose his capital or suffer loss on the investment. To the analyst,
it is the chance that the investment vehicle may not deliver the required or expected returns and thus not
fulfill the financial goals. It is also well established through research over long periods that equity as an
asset class, international as well as domestic, is the most volatile of asset classes. In equities, the
range of returns as well as the potential for capital loss is the greatest, especially in the short term.
While equity may be riskier asset class, it also has the potential to earn superior returns over long term.
It is also well established that over the long term equities, foreign as well as domestic, have delivered
returns much higher than other classes of financial assets. Hence, equities will find a place in every
bodys portfolio but the extent could vary depending on the risk profile, age, need for higher returns, time
frame, etc.
It is important to note that asset allocation should not be confused with simple diversification. Remember,
the more narrowly focused your investments, the less diversified you are. And that can leave your
portfolio more vulnerable to sudden swings in value and increase your risk for significant losses. Here is
an example to illustrate the difference:
Example
Suppose Mr Sharma diversifies risk by owning 10 or even 50 different stocks. He really hasnt done
anything to control risk in his portfolio if those stocks all come from only one or two different industries
in the same sector. Those stocks will often react to market conditions in a similar waythey will generally
all either go up or down after a given market event. This means buying 12 internet or tech stocks will not
give Mr. Sharma optimal diversification; instead he needs to buy stocks of different sizes and from
various sectors.
Approaches to Asset Allocation
Establishing an appropriate asset mix is a dynamic process, and it plays a key role in determining your
portfolios risk and return. As such, your portfolios asset mix should reflect your goals at any point in
time. There are a few different strategies of establishing asset allocation and here we outline some of
them and examine their basic management approaches.
Strategic Asset Allocation
Strategic asset allocation refers to the long term or benchmark asset allocation to each asset class in an
investment portfolio. This involves setting a long-term investment policy, establishing weightings for
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various asset classes, and making few changes over the short run unless there is a specific change in
the investors objectives. The following are its benefits:
Tactical Asset Allocation
Tactical asset allocation can be described as a moderately active strategy, since the overall strategic
asset mix his flexibility to switch over to short-term oppotunities when desired profits are expected. Over
the long run, a strategic asset allocation strategy may seem relatively rigid. Therefore, you may find it
necessary to occasionally engage in short-term, tactical deviations from the mix in order to capitalize on
unusual or exceptional investment opportunities.
This flexibility adds a component of market timing to the portfolio, allowing you to participate in
economic conditions that are more favorable for one asset class than for others.
This strategy demands some discipline, as you must first be able to recognize when short-term
opportunities have run their course, and then rebalance the portfolio to the long-term asset position.
What factors have to be kept in mind during asset allocation?
There are all sorts of investment recommendations continually flowing from the financial press. The key
question is: Are they suitable for you? Its important to be informed about asset allocation so as to avoid
the one size fits all approach that many investors end up accepting. Asset allocation is the cornerstone
of good investing. Each investment must be part of an overall asset allocation plan. And this plan must
not be generic (one-size-fits-all), but rather must be tailored to your specific needs.
Regardless of the approach you take, be sure that an asset allocation takes into account your financial
profile to the extent feasible. Asset allocation can be an active process in varying degrees or strictly
passive in nature. Whether an investor chooses a precise asset allocation strategy or a combination of
different strategies depends on that investors goals, age, investment time-frame and risk tolerance.
Investors should keep these considerations in mind:
Investors should arrive upon the most suitable Asset Allocation Plan.
Investors should not focus exclusively on market value.
Investors should not dwell upon comparisons of ones own unique portfolio with Market Averages.
Investors should not expect performance during specific time intervals as this investment plan is
expected to perform over a long period of time.
1. Investors goals
To help you determine the mix of investment options that may be appropriate for your investment goals,
ask yourself the following questions:
What are my investment goals?
How much time do I have to reach these goals?
How much can I afford to invest regularly?
How much do my assets need to grow to reach my goals?
How much investment risk am I willing to take to reach my goals?
Diversification is essential for successful investors who have multiple goals with different time horizons.
For example, a 30-year-old unmarried investor is likely to need a different investment mix than a 50-year-
old with two children heading off to college in the next few years. If you are retired, protecting your
principal becomes increasingly important as opposed to growing your investments.
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Sample Aggressive Asset Allocation
An aggressive asset allocation is most suitable for investors with a long-term investment horizon (for
example, 10 years or longer), who tolerate risk well, and whose primary goal is growing their investments.
Sample Moderate Asset Allocation
A moderate asset allocation is most suitable for investors with a medium-term investment horizon (for
example, 10 years or longer), who tolerate risk moderately well, and whose primary investment goal is a
moderate level of growth.
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Sample Conservative Asset Allocation
A conservative asset allocation is most suitable for investors with a short-term investment horizon (for
example, less than 10 years), whose risk tolerance is low, and whose primary investment goals are
generating income and protecting against inflation.
2. Age
Why does age play a crucial role in portfolio building?
Risk appetite reduces with increasing age and responsibilities.
As you grow older, your income levels keep moving northwards but your savings keep moving
southwards. This is because your needs and expenses keep rising along with inflation.
Asset allocation till the age of 40
During the early part of your career (till the age of 40 years), the primary objective of an individual is to
invest in basic necessities for living like mobile phone, car, flat, and the list goes on. Your investments
are restricted to statutory investments most of the times to save tax. Investments into provident fund,
insurance policies and deposits are standard investments in this age group. Investment into equities and
equity mutual funds gradually catch-up. Ideally investments into equities with long-term investment
horizon help in giving a fillip to portfolio return.
Asset allocation from 40 years-50 years
After 40 years of age, capital appreciation remains an important objective for individuals. Therefore, a
more conservative asset allocation with higher tilt towards fixed-income bonds and postal schemes start
happening. Exposure to equities creates balance and help in increasing portfolio returns.
Asset allocation after the age of 50
After 50 years of age, close to retirement, one will probably be more concerned with a steady income at
low risk. Increasingly, at this age, a sizable component of savings is used up for childrens marriage and
in educating them. After retirement, the focus is on a steady income to meet day-to-day needs. With a
limited medical cover at this age and no forthcoming regular income, the investments made in the span
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of 40-50 years of age starts bearing fruit. Equity exposure remains minimal and at times more for balancing
the inflationary pressure.
3. Investment Timeframe
Your Investment Timeframe is how long you will be invested until you need to start pulling money out of
your investment portfolio. The longer you have, the more risk an investor can afford to take. A person
who needs access to his investment funds in 5 years will have a much different looking portfolio than a
person who is going to retire in 35 years.
4. Risk Tolerance
This can be defined as your comfort with the potential for investment loss in exchange for a potentially
greater return. Recent market volatility has made it more important than ever to consider the relationship
between risk and return when investing. Risk tolerance is a measure of your willingness to accept
investment risk in exchange for higher potential returns. Risk is the uncertainty of earning your investment
returns and is measured by the volatility of investment.
When you invest, the weight you give to each of these two desires is commonly known as your risk
tolerance. Knowing your risk tolerance will help you identify your investment profile and decide how to
allocate your assets.
For example, if youre an aggressive investor, youre likely willing to accept the risk of losing some of
your investment capital (that means a negative rate of return) in exchange for earning higher potential
returns. A conservative on the other hand, is less willing to accept risk, even for higher potential returns.
Capital is a top priority for conservative investors. As a result, they tend to favor conservative investments
such as certificate of deposit, money market accounts and government bonds.
Your risk tolerance depends on many things, including:
Your goals and time frames. You most likely have several goalssuch as your childrens education,
a vacation home or an early retirement. You may be willing to take more risk with some goals than
with others, depending on your time horizon for each goal.
Personality. Some people are simply more predisposed to take lesser or greater risk.
Income and asset base. The larger your income and asset base, the more risk you may be willing to
take, again depending on your time frame. Some investors with a large asset base, however, may
choose a more conservative approach, knowing they dont need to take on additional risk to meet
their goals.
Portfolio Rebalancing
Once an asset allocation plan is finalized, then securities are chosen for investments and the investment
process is completed. Thereafter, the portfolio of investments comprising of debt, equity, etc. should be
monitored on a periodic basis. The frequency of review could be once in six months or even once a year.
A higher frequency is generally not necessary for a long term investment plan but sometimes, some
economic developments may necessitate an urgent review.
One of the most important factors that will have a big influence of the performance of the portfolio is the
interest rate (which generally moves with inflation). Whenever large scale and protracted interest rate
movements are expected, then a rebalancing will become absolutely essential. In a rising interest rate
scenario, corporate profitabilites will suffer and consequently, stock prices will fall. Bond prices dip to
adjust to the current yields of the market. Reducing equity exposure of the portfolio may become necessary
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and moving from long-term debt swiftly into short term or from fixed rate long-term debt funds to floating
rate and short term debts could also become necessary. If economic slow down is seen through falling
growth rates, then portfolio rebalancing will become necessary again. These economic factors are
external factors that will have to be taken into account as their long- term impact on the portfolios will be
severe and hence suitable rebalancing will have to be done. It should simultaneously be remembered
that these are turn around situations and these happen over long term.
There can be some internal family developments also that may make portfolio rebalancing necessary. A
portfolio is built to meet certain financial objectives; not all objectives are met at the same time. One
after the other the financial goals get completed, over a period of time, as the investor gets older and
older. Some of the common objectives are buying a bigger home, buying a new car, education of
children, marriage of children, retirement capital etc. As these objectives are fulfilled, the return requirements
may come down and it may be necessary to switch to less aggressive asset allocation plan reducing
the exposure to equities and increasing the exposure to debt may be made.
It is an established fact that a rebalancing strategy cannot increase expected return but on the contrary,
rebalancing costs definitely reduce expected returns.
The best rule of thumb of rebalancing is to look at the overall stock/bond ratio quarterly, since it is the
primary determinant of expected returns, and examine individual equity asset classes once a year or
so. Rebalance only when asset classes, and particularly, the equity/fixed ratio, gets out of balance far
enough to produce a significant expected difference in returns.
A portfolio revision may become necessary because of government policy changes, economic factors of
growth rate, budget and fiscal deficits, inflation and interest rates, strength of domestic currency, etc.
While implementing the investment plan, certain securities were bought based on their and the overall
economic fundamentals. These factors may change over time; fortunes of companies also fluctuate,
generally in line with the overall economy but some times on their own as well. For example, a strong
domestic currency may not be good for export oriented companies but will benefit import dependant
companies. A lower interest rate on loans may not be good news for banks and financial institutions but
good news for consumer durables, automobiles and housing sector as the same spurs demand. While a
Buy and Hold strategy is fine, it makes sense to observe crucial economic factors that may specifically
affect some of the securities held and it would be prudent at time to switch out of these securities and
move into others.
To conclude, asset allocation is a fundamental investing principle because it helps investors maximize
profits while minimizing risk. The different asset allocation strategies described earlier can help any
investor do this regardless of his risk tolerance and investment goals. In turn, choosing an appropriate
asset allocation strategy and conducting periodic reviews will ensure you maintain your long-term
investment goals and reach your desired return at the lowest amount of risk possible. The best way to
acquire and accumulate wealth is to develop a strategy, and stick with it. Review your holdings every
year, and make adjustments to keep the percentages where you want them to be.
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Chapter Review