Portfilio Ideas. How to choose asset classes

When it comes to taking investment decisions, having too many choices can be confusing! At the macro level, your choice of asset classes is important, for asset allocation is a significant driver of portfolio returns. In this article, based on your risk tolerance, we discuss how to create a simple portfolio by choosing fewer and appropriate asset classes to achieve your life goals.

Your investing life can be broadly divided into two — investing during your working life and investing during your retired life. Your investment decisions are driven by your ability to earn active income and your human capital. Human capital, in turn, drives your risk tolerance level. For the uninitiated, human capital refers to the skills, knowledge and experience that an individual possesses.

During your working life, you will have several life goals, including meeting your children’s college education, buying a house, vacation spending and building a retirement fund. In a core-satellite framework, this means you will have several core portfolios and one satellite portfolio. Your core portfolio will be goal-based whereas the satellite portfolio will be geared towards capturing short-term movements in the financial markets.

Given this, you should have only two asset classes in your core portfolios during your working life — equity and bonds. Why? Bonds provide stable cash flows. If you want to achieve a goal in seven years, you should invest in a seven-year cumulative bank deposit. That way, you know at the time of investment as to how much money you will receive seven years hence. But you cannot achieve your goals by investing only in bank deposits as they offer about 5 per cent post-tax returns. You need to invest in a higher return-generating asset to save less and yet achieve your life goals. That is why you should include equity in your core portfolio.

You should not add any other asset class to your core portfolio. Why? You do not need rental income during your working life. Land is illiquid and requires lumpy investment. So, real estate may not be appropriate for meeting your life goals during your working life. Commodities and currencies are too volatile to be part of your core portfolio.

What about your satellite portfolio? Your objective is to make short-term gains from capital appreciation. So, your best choice will be equity, specifically direct investment in stocks and trading in equity derivatives. You should also consider commodities — gold ETFs and commodity derivatives.

During your retired life, your preferred asset classes should be bonds and real estate. Bonds (read monthly income bank deposits) can provide you a steady stream of income. So can real estate, through rental income. You need some equity in your retirement income portfolio to beat inflation, especially health-care inflation, which is typically higher than general inflation. It is a moot question whether you need a satellite portfolio during your retired life. If you decide to have one, you should restrict your choice of asset classes to equity and commodities.

Throughout your investing life, you should think twice before investing in currencies. Why? Given the complex global markets and dynamic monetary policy followed by the central banks, currency markets can be risky for individual investors. However, you can choose to have currency in your satellite portfolio if you hire an investment professional to mange your money or if you base your trading decision on technical analysis.

There is another asset class that you can consider during your entire investing life — passion assets. Passion assets include collectibles such as antiques and paintings. You can derive two benefits by investing in passion assets. One, such assets, though illiquid, can generate substantial returns. And two, being physical assets, passion assets are investment assets that can be “consumed”. You can also derive satisfaction from “touch and feel”. You should invest in passion assets only after allocating the required amount to your preferred asset classes during your investing life.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in