Too often financial planning is made out to be simpler than it is. Of course, at a level financial planning is relatively uncomplicated. But that does not mean that it's only about identifying investment objectives and outlining an investment plan that will help you get there. It does involve both these elements of course, but there is an equally important element that is often ignored -- asset allocation.

Now asset allocation may sound like a complicated concept, but isn't. As the word suggests, it means distributing your money across various investment avenues or assets so that the poor performance of any one avenue/asset does not jeopardise the entire investment plan. As logical as that sounds, it is one of the rarest traits in a financial plan, but more on that later.

To better appreciate how the right asset allocation can add value to an investment plan, let's first understand what it's all about. When you look at the investment landscape there are a lot of assets (which loosely refers to investment avenues) and as an investor you really don't know a) which asset must form part of your investment plan and b) if it must, then how much of it should you own.

The answers to these questions are simple, yet not so simple. To the first query -- 'which asset must you own' most investors would qualify to own all the key assets viz. equities, debt, real estate, gold and cash. The answer to the second question -- 'how much of each asset should you own' is a little tricky, because it will vary from investor to investor. An honest and experienced financial planner will certainly play an important role in helping you determine how much each asset must contribute to your investment plan.

A place for every asset

To be sure, every asset has a role to play in your portfolio. And equally important is the allocation of each asset. Put simply, an investor who can take risk will appreciate that he must include equities in his portfolio. But that is just half the story; the other important half is about how much equities the investor must own in order to achieve his investment objectives effectively.

Once he resolves this query he must move on to the next asset, say fixed income (or debt). The same question surfaces -- how much fixed income? Then how much real estate and so on. Piece all these assets (along with their allocations) together and you have what is commonly known as an asset allocation plan.

Click here to download for free - The definitive guide to Financial Planning

Why asset allocation

When you diversify across assets you give yourself a lot of leeway to counter market uncertainties. Till the time an asset market like the stock markets for instance, are progressing well, you probably cannot appreciate the importance of asset allocation. In fact, you may even feel that asset allocation is a hindrance as having all money in equities is a smarter way to ride the stock market rally. It usually takes an adversity (in this case, a sharp fall in stock markets) to fully appreciate that having more than one asset in your portfolio can be a big bonus

Assets have varying cycles; put simply, these are the ups and downs in the assets' fortunes. Not all assets move in the same direction at the same time, in fact, that is a rare phenomenon. This means that if stock markets are witnessing a prolonged rally, then it is unlikely (except in very rare cases) that other assets like gold and property will also witness a sharp upturn at the same time. On the same lines, if stock markets are in the midst of a prolonged bear phase, (again in very rare cases) other assets are unlikely to be in the same situation. Bottom line is since you do not know which asset is going to be at which stage at a particular point of time, its best to invest in more than one asset so as to improve your chances of achieving your long-term goals with minimal turbulence.

The reason why having more than one asset can work in your favour over the long-term is because different assets react differently to the same set of factors. For instance, inflation which can be a negative for stocks in the short-term, could actually lead to a rise in gold prices (as investors move from currency denominated assets to 'real' assets).

So what can asset allocation offer investors? Plenty, if executed correctly. The advantage of having different assets in the portfolio is that a decline in any one asset can be partially offset with the presence of other assets, which are not witnessing the same trend (in this case a decline). This is what diversifying across assets can do for you. If it weren't for asset allocation, you would be a sitting duck every time there was a decline in the prices of stocks or real estate or whichever asset dominates the portfolio and if you aren't adequately 'covered' with investments in any other asset. Now you know why a Swiss army knife (as opposed to a simple knife) can be such a handy tool outdoors, because it can do so many things for you.

As we have mentioned, asset allocation is done best by the investor with his financial planner sitting across the table after giving due weightage to the investor's risk profile and investment objectives. To give an idea, let us consider two individuals Kumar and Vivek. Kumar is a 30-Yr male who is married, no children. Vivek on the other hand is 55 years old, married with children who are on their own. According to the Personalfn's Asset Allocation Review, their asset allocation should be as follows:

	Kumar	Vivek
Fixed Income	10%	20%
Equities	30%	20%
Property	50%	50%
Gold	5%	5%
Cash	5%	5%

Since Kumar is young and has appetite for risk, he should invest in stocks/equity funds (30 per cent of assets) as equities can add considerable value to the portfolio over the long-term. His investment in fixed deposits/bonds (10 per cent) is on the lower side, mainly to provide stability to the portfolio. His property (50 per cent), although accounting for the highest proportion of the portfolio, is largely for residential purpose and not investment.

The balance is in gold (5 per cent) for diversification (since gold is a hedge against inflation) and in a savings bank account (5 per cent) to meet emergencies.

Compared to Kumar, Vivek's asset allocation plan reflects his advanced age and lower risk appetite. To that end, he has 20 per cent (of assets) in equities and 20% in fixed income. His allocation to property (50 per cent), gold (5 per cent) and savings account (5 per cent) is the same as that of Kumar.

The asset allocations must be treated as indicative. An honest and competent financial planner is best equipped to recommend an asset allocation that accurately reflects your risk appetite and is geared to achieve your investment objectives.

Also, asset allocation is not a one-time process; rather it must be pursued on an ongoing basis. This is because with the exception of cash, all assets (like equities, debt) are market-linked. With the passage of time, the allocations to these assets will shift from the original allocations. For instance, it is possible that after a rally in stock markets your equity allocation has increased considerably from what it was before the rally. However, your risk appetite is the same; to reflect this reality, you must re-adjust the higher equity allocation by selling the excess equity and increasing allocations to other assets. The objective is that over a period of time, you must be as close to your original asset allocation as possible.

Any financial plan that aims at realising pre-determined investment objectives without diversifying across asset classes is doomed to fail. We aren't talking theories over here, this is reality. Every time there is a rally in a particular market, investors flock to it ignoring the basics of financial planning. A rally in technology stocks often means investing only in technology companies. An upturn in real estate means ignoring other assets for the lure of real estate (or real estate stocks). A surge in gold prices, means buying gold to the exclusion of other assets.

Of course, this kind of investing is a combination of several factors; one is the rally in the asset itself, other factors are greedy intermediaries and media hype. The intermediary (from commissions) and media (from advertisements) make their money from all the hype, but the retail investor is sitting on a disaster that is waiting to happen. When the rally (in the asset) fizzles out, the retail investor is usually the biggest loser since he is the last to get out. This could have been averted very easily if he were prudently diversified across assets with no single asset occupying a larger-than-necessary share of his investment plan.

This article has been sourced from the July 2007 issue of Money Simplified � The definitive guide to Financial Planning.

How not to lose 2,296% returns! Do not buy mutual funds until you have read this. Click here!