Whatever asset allocation you choose, if it keeps you awake (and your planner too) at 3 a.m., it is not a good equation that you have got. Set it right soon.

When three of my clients came to see me for a portfolio review, I realised what a difficult job I had on my hands. Dilip, Devrajan and Kavya, the very convenient names of my three clients had such different but risky portfolios that my work was cut out.

Dilip had a portfolio of Rs 6 crore (market value had cost him Rs 3.6 crore about three years ago) in two properties in Mumbai. Both were funded by loans (amounting to Rs 3 crore). Both the properties were given on rent, and luckily for him the current rent was greater than the EMI (equated monthly installment). This was, of course, because the EMI was for a period of 20 years, and Dilip was sure as the rents went up, the situation will only look better.

Devrajan had come to me in 1999 and even though he was in a brokerage firm and had some ESOPs (Employee Stock Ownership Plan) in that company, his portfolio was completely in the debt market -- Reserve Bank of India [Get Quote] bonds, income funds, and bank fixed deposits. Out of a portfolio of Rs 4.5 crore, he had Rs 20 lakh in equities -- held without much conviction. He felt equities was too risky.

Kavya was the flamboyant type, who had worked in a pharmaceutical company, had no savings, no investments, and a kingly bank balance of Rs 340,000 all in the savings bank account.

The savings were all in National Savings Certificate, Life Insurance Corporation policies, Public Provident Fund, own Provident Fund -- all done to save tax. However, when she met me in 1999, I introduced her to equities.

I now had the enormous task of making a concept called 'asset allocation' and risk protection for these three.

Dilip, for example had no liquid cash and the only asset other than the two flats, was a small LIC [Get Quote] policy, and some cash balance in his savings account. He is a senior manager at a business process outsourcing (BPO) unit, has a Rs 45 lakh job, is 40 years old and has two grown up children.

His wife runs a boutique that makes no money. I convinced him that he needs Rs 6 crore insurance cover, and he should do a systematic investment planning (SIP) in an equity fund from the rent that he receives.

Dev, luckily, had started an SIP in 1999 in equity funds, and now was happy that he asked me to review his portfolio in 1999. A very strong believer in financial planning, he was convinced he could do it himself.

I just highlighted the risk of inflation and putting all money in one asset class. He now had about 20 per cent of his portfolio in excellent equity funds, which had also given him some sensational returns. He had also converted some of his income funds into equity funds, and was beaming and happy.

Kavya was my biggest problem -- she thought I was a magician and I had created the returns for her. She started calling me her lucky charm -- and would introduce me as a 'luck charm' to her colleagues. Now, she is such a convert that she thinks all moneys should only be in equities.

There is a human tendency to think that the immediate future will be same as the immediate past. Though empirically, this is never true in our lives, we do not accept that. Not carrying an umbrella today, because it did not rain yesterday is perhaps the best way to get drenched. Is it not?

For a client to sell a portion of the 'success' that he is riding sounds sacrilegious, so how does a financial planner convince him the need to do so?

Only be appealing to his senses that traditionally equities have given 17 per cent return (over long periods of time) at a time when inflation used to be 10 per cent. Hence, a return of 59 per cent or 75 per cent is an aberration and not sustainable.

Let's say, you listened to your financial planner and had the following asset allocation in the year 2001:

Now assume over the last three years, the equity markets had done well (it actually did) and now your portfolio allocation looks as follows:

What has happened in your life? You have got older (i.e. to say your goals have got five years closer) and your asset allocation has gone more in favor of a more volatile asset class. This is, theoretically risky.

Now, I have the great (and highly unpleasant too!) task of asking you to remove money from your best performing asset class and put it into your worst performing asset class. That is tough, but an important part of my job. I need to ask you 'Do you accept the attendant risk of such an asset allocation?'. . .

In simple terms, asset allocation is spreading your money across various assets -- be it cash, real estate, commodities, equities, bonds, etc. If your investment philosophy is clear -- i.e. you know what your investment portfolio has to achieve, doing an asset allocation is easy.

All portfolios should normally aim at three things -- growth, income and cash. Arguably, if you are young, you can look at growth and liquidity and when you are retired you will look at income, liquidity and growth -- in that order.

How much of your assets should be in a volatile asset class depends on your needs. For example, a 65-year-old person with a Rs 4 crore portfolio (and annual expenses of Rs 200,000) and a life expectancy of 15 more years, can choose a full debt portfolio (and reduce volatility and return) or decide to put 80 per cent in equities hoping to leave a sizeable chunk of his portfolio to his grandchildren.

It is a matter of choice. However, whatever asset allocation you choose, if it keeps you awake (and your planner too) at 3 a.m., it is not a good equation that you have got.

The author is a financial domain trainer. He may be reached at pv.subramanyam@moneycontrol.com