While most of us were spending sleepless nights mulling over the world wide slide in equity markets, and the deep gash its left on our portfolios, a few smart investors have been going about their life as usual. They take comfort in the fact that their investment portfolio is adequately insulated; that the greatest determinant of their portfolios return is the asset mix in their portfolio, which has helped reduce the ill effects of volatility.

Invest in equities preferably for long term: Today if you were in a position to stay invested for 20 years or more, you should not be looking at any other asset class other than equity, it has clearly out-performed all other asset classes (other that real estate in select areas). But most of us are not tuned to investing with such a long time frame clearly mapped out in front of us. While all of us have goals which are long term we invest with a short term mind set. There is a theory which shows that most of us sell our profits very fast and hold on to our losses for long. It’s in fact so ironical that equities which should be invested into only with a long term horizon, is the one asset class most people tend to move in and out off the most. Most of us are in the habit of continuously monitoring our portfolio on a daily basis, some of us have got into the nasty habit of looking at it every hour. This kind of obsessed nature has resulted in us taking decisions which are not conducive to our portfolios long term growth.

Financial Planning and Asset Allocation can help in reducing your portfolios volatility in the short term and more importantly provide some much needed discipline to your investments by providing a basic road map for your savings strategy.

Don’t have an asset allocation? You’re shooting in the dark: All of us spend a huge amount of time, researching on our own as well as on tips, deciding which stocks to buy and which to sell and whether its time now to get into debt. While all of these are genuine concerns which investors must face, your success as an investor as well as your achieving your long term financial goals is deeply entrenched in your asset allocation decision which is more or less stable in the long term.

We have heard of the adage, advising us not to keep all our eggs in one basket. Most of us believe that we are firm followers of this policy, but nothing could be further from the truth. While I agree that we all have some kind of asset allocation in place, how many amongst us have actually planned what asset allocation suits him/her the most. Most of us have some vague idea of the risk we can tolerate and decide that we should invest an “x” percentage of our total assets in equities or fixed income assets. The balance follows through from this decision. What we do not realize is that, no matter what our attitude to risk, we are saving towards certain goals, and to make sure that we achieve those goals, we have to either stretch ourselves and save more or make our money work harder.

Its easier to change your asset allocation than your level of saving: While most people may start their financial planning with their goals and risk tolerance, which in turn determines their asset allocation strategy, and then go on to decide how much more they have to save, I am of the opinion that most people would find it easier to change their asset allocation (in favor of riskier assets) then they do their level of saving. Let’s move on to how you should go about dividing your assets between different asset classes. Every investor faces the challenge of balancing downside protection (against capital loss) with upside potential (for high returns). People are more sensitive to losses than they are to gains of the same magnitude. Your need for downside protection is also a function of the length of your investment horizon (how long before you’ll need the money) and whether or not you are making regular withdrawals from your savings (as would be the case, for example, if you were gradually drawing down your savings to pay your bills during retirement). The shorter the time before you need the money, and the more you’re planning on taking out along the way, the more downside protection you need.

The degree of mismatch between your current and expected savings and your financial goals tends in practice to create situations where the amount of downside protection you want is less than the amount you can afford (in terms of foregone returns on higher risk assets). In other words, there is usually a tradeoff between your lifestyle, your financial goals, and your asset allocation.

As with so many other things in life, there is no free lunch here either!Different asset classes provide different degrees of downside protection and upside potential. Broadly speaking, our economy can be in one of three states: normal, high inflation, or deflation. In the normal state, we don’t need as much downside protection as we do in the other states, and look to equity type investments to generate high returns for us. In the inflationary state, we look to asset classes like real return bonds (not available in India as of now) and commodities (and possibly real estate) to protect the purchasing power of our capital. Finally, in the deflationary state, we look to investment grade bonds to preserve our capital while maximizing our real returns.Those of us who have a portfolio skewed towards equity you might as well book profits as soon as the market recovers and rebalance your portfolio so that you have a healthy mix of asset classes, while those people who do not have or have a very low equity exposure, there is no time better than right now to start investing slowly but surely into equity. As a general guide (very bookish!) you may consider following, any of the general asset allocation strategies which divide your portfolio based on your risk profile. There are scores of such asset allocation guides available over the net and they do a fairly decent job of giving a mix to your portfolio. For a more through understanding of what asset allocation suits you, it’s important to understand your goals, your ability to save, the risk you can take, and your time horizon.

Do not club all your goals into one: You will realize that you cannot club all your goals into one and that each goal has a different time to maturity. It will require you to have a different asset allocation towards each financial goal. This means that each individual amongst us will need a different asset allocation to suit a variety of different goals which arise during our life time. This makes it important for each person to have a financial plan for themselves from which the asset allocation decision can be derived. One of the most important decisions you will make in your life will be the asset allocation decision of your savings. Not having an asset allocation strategy in place is like shooting a moving target in the dark, you are sure to miss, but the worst part is that you would not know that you missed until it’s too late.Most of us have in place an asset allocation of our investments without even being aware of it. Haven’t we all at some time consciously decided ‘how much’ to put into those PO Savings, Bank FDs, 9% Senior Citizens, Balanced MFs , the MIPs, the ELSSs and finally the diversified equity funds and direct equity. It is this initial asset allocation which has sub consciously defined our returns. So you may ask, if all of us follow asset allocation in practice why do we still suffer so badly during these market crashes?

Review your asset allocation at least once a year: The answer is in the fact that even though all of us have some sort of asset allocation in place, it is no longer the same asset mix we had initially planned and perhaps ‘documented’. It’s a policy which we had put in place sometime without serious consideration and didn’t bother to follow up on. This results in your asset allocation not being in tune with your risk appetite and getting skewed towards asset classes which are currently the market flavour.

Most of us would have, over the past one year, seen that our equity portfolios had swollen alarmingly, and yet we continued to pump additional money into equity. This in the end resulted in our portfolio getting so heavily biased towards equity that when the markets corrected it hurt us much more than we could tolerate. A more pragmatic approach would have resulted in us booking some profits or making fresh investments in Fixed Income securities only. This would have moved our portfolio back to our original asset allocation and thus to a risk tolerance we would be able to digest.

While all this sounds like good advice in hindsight, you must remember that this is not ‘me’ timing the market or advising you on market direction, but an automatic way to ensure that your portfolio is always balanced and in-step with your asset allocation.

You will thus realize that financial planning is an extremely important tool to build long term savings. Realising ones financial goals does not involve only putting in place a financial plan but also following it up regularly and taking action as and when required. It’s also important to remember that our risk tolerance and saving capacity keeps changing with the size of our personal balance sheet and cash flow, so having a review of ones financial goals and saving pattern once a year is extremely important. Remember your asset allocation is a function of your risk profile, financial goals and saving capacity. All these 3 are dynamic and keep changing with time and situation, so it’s imperative that you re-visit your financial plan at least once a year for a review. A well documented plan will also ensure that you stick to the same during all times and thus reap the benefits of regular investing.