If one puts all the eggs in one basket, the chance of all the eggs being broken are more. If one puts them in three or four baskets, the chance of breaking all of them will be less. In the event of an unfortunate incident, the loss will be reduced. Same thing is applicable for investments. If one invests all the assets in equity, the portfolio value will come down once equity market crashes. So the solution lies in diversification.
Diversification is the process of investing in different asset classes in different proportions. It depends on investor’s goals horizon and risk appetite. Diversification cannot reduce the risk involved in a particular investment asset and does not guarantee better performance.
Diversification is an effective strategy to protect the portfolio from volatile markets. In 2008, equity market crashed while commodities boomed; in 2009, debt did’nt do well as equity returned back; in 2010, equity boomed again, even as commodities corrected; in 2011, gold appreciated while equity again crashed; and in 2012, debt is doing well even as equity is languishing.
Goal horizon is the number of years left for the goal. It depends on the life stage. At a younger age, retirement is the farthest goal unless one thinks about early retirement. Buying a house or a car are nearer goals. Children’s education and marriage are medium term goals.
The risk appetite has three components i.e Willingness to take risk, capacity to take risk and need to take risk. The willingness to take risk is a psychological attribute specific to each individual. The capacity depends on the cushion available to absorb the reduction in the value of the assets or unexpected increase in liability. The need to take risk is based on the objective analysis which is best assessed by afinancial planner.
One may reduce the portfolio risk by investing in different assets like equity, debt, commodities and money market securities. The thumb rule for equity exposure is equal to 100 minus current age. For example, if one is 35 years old, he/she may keep 65% (i.e. 100-35) in equity and the rest in others ; say 20% in debt, 10% in gold and balanced 5% in money market securities. One needs to reduce the equity exposure and increase debt exposure nearing retirement.
When Equity is suitable?
One, who is young and want to invest for future goals say 10-15 years away like children’s higher education, children’s marriage and retirement corpus, needs to invest higher portion of income in equity. The value of equity assets may fluctuate in the short term, while the appreciation may be significant over the long term. Hence, equity are suitable for long-term goals.
When debt is suitable?
After retirement, one will need regular income. Further retirement corpus cannot be subjected to volatility of market. So it is always advisable to park retirement corpus in fixed income debt security which has low risk.
Investment in Real estate.
One must invest in a dwelling house/flat. It provides capital appreciation and generates rental incomes if rented out. Investment in residential house is advantageous from tax point of view. Banks provide loan for construction and buying of properties. But the equated monthly installments (EMI) should not normally exceed 40% of the take home salary. Investment in land at upcoming locations gives good appreciation. But there are risk of encroachments for which one need to be watchful.
Benefits of Gold ETF
Currently gold is a good investment vehicle. Investing in physical gold has risks of purity, safety and liquidity. The gold ornaments are also costlier due to inclusion of making charges and has risk of storage. From tax point of view, Gold ETF has advantages over physical gold. For getting long term capital gain tax benefits, physical gold has to be held for 3 years and above visa a vis 1 year for Gold ETF. Similarly wealth tax is payable for physical gold. But for holding Gold through ETF, one needs to have a Demat account. But in case Demat accounts are not there, e gold can be bought through Mutual Funds.
Investing in Gold through E gold is very convenient.
Benefits of diversification
Investment assets can be aligned with investor needs and risk appetite.
Investing in various assets ensures a stable rate of return.
Different assets do well at different points of time; if a portfolio is well diversified, the risk of the portfolio reduces.
- Invest for long term.
- Invest regularly.
- Invest in a diversified manner
Author : Prakash Praharaj