Asset classes are clusters of financial instruments available to investors, to meet their financial goals.
Broadly, asset classes are divided as follows –
- Stocks (Equity)
- Bonds (Fixed Income Instruments)
- Cash Equivalents (Money Market Instruments)
- Real Estate
- Cryptocurrency and Non-Fungible Tokens
We start financial literacy lessons with Elizabeth Warren’s rule of 50:30:20, and budgeting tools. But it need not always be 50:30:20. It can be any ratio of fixed costs: discretionary costs: savings you find convenient.
The question that arises after this what do you do with the amount saved. Money needs to be invested to generate returns and become wealth. How and where do you park your savings, to build up a good net worth?
Asset classes or financial instruments enter the picture here.
You need to consider the following factors.
- Ticket size
- Taxability of income
- Tax deduction
Needless to say that the final allocation should intermesh with your financial goals and time horizons.
RISKS TO BE CONSIDERED
1. Inflation Risk
It needs a few calculations and extrapolation with an assumed figure of inflation rate.
2. Interest Rate Risk
It is a difficult task to predict interest rate patterns for long periods. One must proceed ahead on the basis of certain assumptions and accept the risk.
3. Liquidity Risk
It is the inability to convert assets into cash when needed in a short time frame.
4. Market Risk
All predictions about the stock market are based on history, economic cycles, and assumptions about future course of events. Yet, Black Swan events do happen. Trusted blue chip companies do deliver less than stellar results. The timing of entry and exit also matters.
4. Credit Risk
A default on debt instruments can happen with bank failures or frauds in money markets.
Recent examples are AT1 bonds issued by Yes Bank and Franklin Templeton debt funds.
Why don’t we have cut-copy-paste formulae which everyone can apply?
Because money involves a lot more than arithmetic, procedures and techniques. It’s a lot about the mindset.
BEHAVIORAL BIAS IN CHOICE OF ASSET CLASSES
We hardly ever accept 100% advice of a financial planner. There are many other factors that weigh heavy on us.
1. Availability heuristic
This sounds a little absurd with online availability of most financial instruments. Yet, we tend to stick with what our bank or stockbroker offers, or the plan our financial advisor executes.
The tendency is to go with readily available information, rather than scanning and researching more data.
2. Confirmation Bias
We listen only to those people who echo our own thoughts and deceive ourselves that we have sought opinions from others.
3. Familiarity Bias
Many people are reluctant to put their money in an instrument they know nothing about. This bias is not always negative. What is lacking here is the effort to understand and get familiar with new options.
4. Herd Mentality
We go where the crowd is going. It happened with cryptocurrency where people jumped into investing without any research on popular coins.
5. Loss Aversion
We stick to safe instruments with guaranteed returns. The risk appetite is low.
6. Recency Bias
Our decisions are impacted by recent events. It is true of both positive and negative experiences. We extrapolate the event into the future and expect a repeat.
The following are two main types of asset allocation.
1. Strategic Allocation
This method focusses on your financial goals.
2. Dynamic Allocation
This method involves elements of choice and flexibility in changing the course of investments. It suits high net worth individuals with a large corpus to invest.
Not to say that this categorization is watertight. Everybody needs an element of flexibility, and the freedom to choose a plan compatible with temperament and convenience other than financial goals. Financial plans cannot succeed without the right attitude and a certain amount of discipline.
CHOICE OF ASSET CLASSES
The first step is understanding the nature, product types, safety and liquidity and suitability for different age groups and risk appetites.
We will delve deep into each asset class in weeks to come.
Meanwhile, a recommended book for Indians is Demystifying Asset Classes by Sandeep Sahasrabudhe.