Both these approaches expose them to different types of risks. While ultra-conservative investors end up compromising on their long-term goals as their portfolios fail to keep pace with inflation, the aggressive investors often make irrational investment decisions in their pursuit for that ever-eluding financial windfall.
Therefore, if you are in the process of working out your investment strategy, you must adopt one that helps you design a portfolio that suits your requirements without exposing you to unnecessary risk. Remember, asset allocation strategy i.e. investing in different asset classes based on your time horizon, goals and risk-taking capacity is one such strategy that allows you to keep your risk within your risk-taking ability.
Since investing money judiciously is becoming more and more challenging, having a financial plan in place can ensure that you allocate appropriate sums for your different needs and requirements. Simply put, financial planning can help you make informed investment decisions by having an appropriate risk-reward balance in the portfolio.
There are certain basic requirements for financial planning such as defining and setting quantifiable goals, incorporating risk management, understanding the effect of each financial decision and being realistic in terms of expectations.
All of us have goals that we would like to achieve over short, medium and long-term. To ensure that all your efforts are directed in a focused manner, you must begin the process by establishing your goals. Once the goals are established, you must assign a time horizon to each of these goals and quantify them. By setting a target for each of your goals and assuming a rate of return based on the proposed asset allocation, you can work out the amount that needs to be invested to achieve these goals. While starting your investment process early and in the right manner is important, it is equally important to monitor its progress. Therefore, it helps if you create a separate portfolio for each of your goals. This will ensure your complete control over your goals and the progress made towards achieving them at all times.
Make risk management your priority
Risk management should be an integral part of your financial plan. However, we often ignore this important aspect of financial planning process. In fact, even those investors who do alright in terms of their investment process often ignore risk management. This can be quite risky as it is critical to cover risks relating to your life, health and property. Therefore, before starting your investment process, you must ensure that these risks are adequately covered. Remember, buying the right insurance policy is equally important.
For example, paying higher premium for a traditional life insurance policy often makes you compromise on the quantum of risk cover as well as investment returns. A term insurance plan scores over traditional and unit linked insurance plans, both in terms of quantum of insurance cover as well as costs. Therefore, it is always advisable to separate your insurance and investment needs.
Besides, creating an emergency fund equivalent to your six months expenses is also a crucial part of risk management. This emergency fund ensures that your investment process would not get disturbed when you are faced with some financial exigency. Also, don't forget to review your risk management process periodically to further reduce risk.
Select your investment options well
You must start short-listing your investment options only after deciding on appropriate asset allocation . The emphasis should be on investment options that are transparent, flexible and tax efficient. In fact, market linked products should be the mainstay of your portfolio as they have the potential to provide higher returns than traditional instruments like fixed deposits and bonds etc. An investment vehicle like mutual funds fits the bill and hence they should be the mainstay of your portfolio. Mutual funds allow you to invest in different asset classes through a variety of funds.
However, the key is to select your funds well within each asset class. For example, while investing in equity funds, your focus should primarily be on well diversified funds. Investing in aggressive funds like sector, thematic and specialty funds at the start of your portfolio building process can expose you to higher volatility which can create doubts in your mind about the asset class and the utility of this wonderful investment vehicle.
Many investors make the mistake of relying on past performance alone while selecting funds. If you have been following this approach, you need to rethink your strategy. Although, past performance is an important aspect in the decision making process, relying too much on it can backfire. Even while considering the past performance, the focus has to be on the long-term performance rather than the short term one.
For example, in a current market like situation, mid-cap funds or funds having higher exposure to mid-cap stocks, sector and thematic funds dominate the list of top performing funds. A strategy of investing a significant part of your equity investments into these funds can make it too aggressive for your liking and that may at times compel you to make haphazard investment decisions.
Similarly, a performance analysis of equity and equity oriented funds during market downturns would project a disappointing picture. Relying on past performance alone during such times would make it difficult to invest in equities. Hence, you must look beyond past performance to make sound investment decisions.
In keeping with that, factors such as the need to maintain your asset allocation, potential of equities to beat inflation as well as out-perform other asset classes in the long run, might provide convincing reasons to make fresh allocations.
Stay committed to your asset allocation
While a goal-based investment approach can help a great detail in ensuring that you invest with a clear time horizon and avoid making abrupt changes in the portfolio, maintaining asset allocation by rebalancing the portfolio periodically ensures that you remain invested in different asset classes at all times in the proportion that suits your risk profile. As a result, you neither miss out on sudden rallies in the market nor expose your portfolio to too much risk during market downturns.