Wednesday, November 30, 2011

Building Wealth with Wise Investing ...........

Rome was not built in a day. In a similar manner, it is not possible to build enough wealth to achieve all your personal financial goals like retirement, your child's education and marriage, buying a new house and a new car etc, overnight.

Achieving a financial goal is a gradual process with series of considered and deliberate investment decisions.

Almost everyone can accumulate significant wealth over a long period of time by wise investing. And it doesn't take a significant lump sum of money to start investing, all it takes is good sense, and some portion of your income, over a long period of time.

Wise Investing is not about timing equity markets or simply investing in debt when interest rates are at all-time high. It is about being disciplined about investments. Wise investing is about sleeping well at night after investing.
It is the knowledge that you are steadily working towards building the level of wealth you require to achieve all your financial goals.

But where do you start if you want to get it absolutely right?

Here are a few points to be kept in mind before investing:
  • Know how much you can invest per month Realistically assess what your investible surplus is - the amount of money you have left after you have set aside enough to run your house and maintain a contingency fund. You will need to take a good look at your finances and the disposable income you have available.
  • Know which asset class you should be investing in i.e. know your ideal asset allocation. For each of your financial goals, the asset allocation will be different. For a goal that is happening next year, you should not be investing into equity. For a goal that is 20 years away, you should minimize your investments in debt. Your overall asset allocation is simply a weighted average of all these individual goals' asset allocations and amounts.
  • Know your risk appetite and your risk tolerance. It is possible that you are the kind of risk taker that would risk a 50% loss, if the upside means a 50% gain. But can your finances tolerate this level of risk? Or would it be financially easier to handle a smaller gain that comes from risking less?
  • Speak to an unbiased advisor before investing. This is the best way to get a professional view of the investment you are considering. Better yet, ask your advisor what would be a good investment for you to make, considering the various financial goals you want to achieve.
  • Make sure you don't put all your money in one place. Diversification of your portfolio across different asset classes such as equity, debt property and gold is a good way to reduce exposure to the risks of any one asset class.
  • And lastly, to build your wealth, invest your money first and spend what you have left. This is a much better approach than doing things the other way around.

Importance of Asset Allocation

Asset allocation may sound like a complicated concept, but it is really very simple. As the phrase suggests, it means allocating your investments across various investment avenues or assets so that the poor performance of any one asset does not affect the overall performance of the entire portfolio. Different asset classes are differently correlated with one another. For example, when equity does well, debt or gold may not do well, and vice versa. It is this different correlation that makes asset allocation such a critical component of financial planning. Asset Allocation depends upon the following factors:
  • Your risk profile (appetite and tolerance)
  • Your financial goal time horizon
Typically, determining the right asset allocation for you is best done by your personal financial planner. To give a broad idea, let us consider two individuals Mr. Reddy and Mr. Singh.

Mr. Reddy is a 30 year old male who is married and has no children. He wishes to plan for his retirement, and so his goal time horizon is 25 to 30 years.

Mr. Singh on the other hand is 45 years old, married and with a 10 year old child. His goals include buying a house i.e. accumulating a down payment in 5 years, sending his son to college in 8 years, and planning for his own retirement in 15 years.

Current Asset Allocation for Mr. Reddy and Mr. Singh are as follows:
ASSET CLASS Mr. Reddy Mr. Singh
EQUITY 70% 55%
DEBT 10% 30%
GOLD 15% 10%
Mr. Reddy already has his own house and hence his allocation to real estate is simply the value of his own home. Mr. Singh is buying a home for which he is accumulating down-payment funds. When he purchases the home he will be buying real estate and hence adding real estate to his asset classes.

Mr. Singh has a lower exposure to equity due to the higher number of short term goals and due to his higher age which reduces his risk appetite and tolerance. Mr. Reddy on the other hand has higher exposure to equity, a riskier investment, because his only goal is retirement, and the time horizon of the goal is 25 to 30 years i.e. long term. But remember, asset allocation is not a one-time process. It is not static, but dynamic. As your goal draws nearer, it is important to re-assess your asset allocation and withdraw from risky investments - to de-risk your goal's portfolio. You can now decide what your asset allocation should be for each of your goals. Here are some guidelines you can follow:
  • If your goal is more than 10 years away, you can invest up to 70 - 75% of your investible funds into equity, depending on your risk profile. The remainder of your investment can be put into debt (15 to 20%) and gold ETFs (around 10%).
  • As your goal comes closer, for example when your goal is 6 years away, you can maintain an asset allocation of 60% in equity, 30% in debt and 10% in gold ETFs.
  • When your goal is less than 3 years away, it would be wise to not expose the corpus to equity market volatility. Maintain a 100% exposure to fixed income instruments.
Remember - those investors who were invested in equity when the markets crashed in 2008, and had a goal such as their child's education or their own retirement less than 3 years away, have had to watch their goal funds get eaten away in the market crash. They also may not have had enough time to rebuild their goal corpus.
This is why it is absolutely essential to de-risk your goal portfolio as your goal draws nearer. So the first step of building your wealth with wise investing is to maintain the right asset allocation based on your goal time horizon.

So, follow the simple steps listed above and you can be sure that with wise investing, you will build up your wealth

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