Asset allocation should be your top priority

Most investors believe that they need to be an investment expert to achieve investment success. In reality, if they follow basic investment principles, it is not so difficult to become a successful investor.

The legendary investor Warren Buffett has also said: "You only have to do a very few things right in your life so long as you don't do too many things wrong". Unfortunately, many investors don't follow the basic principles and hence end up either taking too much risk or compromising on returns. Here's how you can become a successful investor:

To begin with, you must decide your asset allocation before selecting investment options.  Asset allocation is an investment strategy that helps you decide your exposure level to various asset classes such as equities, debt, real estate and commodities. Simply put, asset allocation as a method of investing should be an integral part of your financial planning process as it not only reduces the risk but also helps in optimizing the returns on a risk adjusted basis.
 
Remember, asset allocation is different from diversification. For example, if your portfolio has 5 equity funds either with similar investment strategies/ philosophies or investing in stocks belonging to the same market cap such as large, mid and small caps, it won't do much to reduce the overall risk. If the market falls, all these funds will react in a similar way. On the other hand, different asset classes will react differently in any given situation.

A number of studies have proved that more than 90 percent of investment success depends upon one's asset allocation and the rest on investment option chosen for each of the asset classes.

However, investors usually end up spending 90 percent of their time and efforts on choosing investment options and the process of asset allocation is ignored. For example, over the last one year, the average return from multi-cap equity funds has been around 65 percent. Of course, if one were to analyze the individual performance of funds, there would be a number of funds that may have done better or worse than the average.

The important thing to note is that during the same period, the average return from short term income as well as funds following accrual strategy has been around 10 percent.
 
As is evident, the major difference in the performance of an investor's long-term portfolio would have come from the selection of asset class. Needless to say, if one chooses the funds well, the performance can be even better and that too without taking any additional risk.

Here too, it is quite common to see investors following "tips' and "recommendations" from their friends and relatives without ascertaining their own needs, risk profile and investment goals.

Remember, the type of asset allocation strategy that can work the best for you would depend largely on your ability to tolerate risk and your time horizon. Risk tolerance is your ability and willingness to take risk in order to achieve higher potential returns.

Therefore, if you have high-risk tolerance, you will have the capacity to take market volatilities in your stride to enhance your chances of earning higher returns. If you are a conservative investor, you would prefer investment options that will preserve your capital. 

Similarly, time horizon is the expected number of years you will be investing for to achieve your investment objectives. If your time horizon is longer, you would generally have the capacity to invest in riskier or more volatile asset classes as you can wait out inevitable ups and downs of the markets. Similarly, if you intend to invest to achieve a short term goal, you are likely to have less appetite for the risk taking.
 
Once the asset class is decided, your effort should be to select options that are tax efficient, transparent, flexible, cost efficient and potentially better than others.

Mutual funds score on all these counts over other investment options and hence they should be an integral part of your investment strategy. Besides, while investing in equity funds, you must begin with well diversified equity funds. It is always advisable to avoid aggressive fund types like sector, thematic and specialty funds at the start of your investment process.

Remember, equity as an asset class is aggressive and hence by investing in aggressive types of funds you would end up exposing yourself to much higher risk and that too without any guarantee of any additional returns.

It is also important for you to know different types of risks associated with your entire investment process. Although most investors focus on market risk, in reality there are a variety of risks that you are likely to face during your committed time horizon.

To begin with, there is a market risk. Market risk is common to all the asset classes in the portfolio. Therefore, the portfolio value may experience ups and down on account of economic changes or other events that impact the marketplace. Diversification and rebalancing the portfolio periodically can help you in managing market risk. Then, there is inflation risk.  Inflation risk is the risk of losses resulting from erosion in income or in the value of assets due to the rising costs of goods and services. It is one of the major risks for investors who invest primarily in debt and debt related securities.

There is also a risk that you may outlive your assets. Hence, you must opt for an asset allocation that has the potential to provide positive real rate of return over time so that you can deal with longevity risk. You may also face behavioural risk if you follow haphazard strategies when faced with uncertainties. This can cause a substantial impact on your investment results in the long run. Therefore, the key is to stick to your investment plan irrespective of the market condition.

Last but not the least, there is sequence risk. Although having a financial plan and following it in a disciplined manner helps, you may still face the misfortune of experiencing a market downturn just around the completion of your time horizon. Therefore, it pays to start protecting gains by altering asset allocation of the long-term goals in a phased manner say around 12-18 months before the target date.

The author is CEO, Wiseinvest Advisors