Good asset allocation = BIG money

Most of us are preoccupied with hunting for that wonderful stock, that great mutual fund or a piece of property that would give returns of 100 per cent or more a year.

Salespersons from brokerages, mutual funds, insurance companies too try to sell us this dream that their pick will deliver that super profit in coming months. It's not that stock brokers proclaim, "Of the three stocks we recommended, one of them has actually lost 20 per cent."

But he will always talk about the one that has delivered 120 per cent. This brings us to the basic question, "Is it really worthwhile for us to spend so much time and money in looking for the super performers among different stocks and funds?"

Let's try to answer that through a real life example. Anuj and Manish buy and sell shares through the same broker. About a year back, their broker recommended the same four stocks to both of them - Tata Elxsi, SKF India, India Infoline and Bajaj Hindusthan. Each of these stocks are from different sectors - IT, auto ancillary, financial services and sugar.

Based on the broker's recommendation, Anuj bought two stocks - India Infoline and Bajaj Hindustan. He believed that of the four stocks, these two would be his winners. On the other hand, Manish spread his investments and bought all four stocks in equal proportions. India Infoline out-performed all the stocks, delivering 141 per cent return.

Since Anuj had invested half his money on India Infoline, he is bound to be gung-ho about the fact that his stock shot up by 141 per cent. In comparison, Manish had only 25 per cent of his investments in this stock. But hold on...Manish's overall returns are higher.

As we can see from the table, Anuj's annual returns from his portfolio is 42 per cent while Manish is placed slightly higher at 46 per cent. So, in spite of having a lower exposure to the top performing stock, India Infoline, Manish was able to earn 4 per cent higher than Anuj. And Manish hardly made an effort to pick and choose. Instead, he divided his investible funds equally among all the four stocks.

Of course, this is not to say that Anuj would always under-perform Manish. In fact, he would have performed better if he had invested his entire investible funds in India Infoline.

But he could also have actually eroded his principal by over 50 per cent, if he had gone by past trends and invested the entire amount in Bajaj Hindusthan, which rose by almost 200 per cent between the same time period a year back. That is the problem of putting all your eggs in one basket.

On the other hand, Manish remains diversified each year in many stocks, his portfolio will not incur as huge a loss compared to Anuj even if he too had Bajaj Hindusthan that year.

Similarly, without spending too much time hunting for the ideal real estate to get best returns, had you parked part of your investments in any real estate couple of years back, you would have made quite a bit of money in the ensuing boom.

But you need to ask yourself whether this rise of 100 per cent is a result of your property selection or because of the boom in the property market?  Selection may not have played a big role in the whole process.

Others may not have made 100 per cent but could have made more or less, depending on a lot of factors like their ability to fund the property they want and other factors. Not convinced? Let us take this argument to the next level.

What happens when the whole market comes crashing down? During May 2006, in a short span of a few weeks, Indian stock markets lost about 25 per cent of value. Irrespective of how many stocks one bought across different sectors, most likely all your stocks would have lost substantially. And if most of your money was parked in equity, imagine the erosion to your net worth in a mere 15 days. In this case, all and sundry would have lost pots full of money.

So that brings us to the next point. Similar to selecting many stocks, you need to put your money in different asset classes as well. The most common asset classes available are equities, fixed income, real estate and commodities. In financial parlance, investing in different asset classes is called asset allocation.

Investing 30 per cent in equities, 50 per cent in real estate and 20 per cent in FDs would be an example of an asset allocation.

One-year returns:

And very much like individual stocks, it is difficult to predict which asset class will do well over a particular year. So it is best to keep yourself diversified over all of them all the time.

How much to invest in each class will depend on various factors like your objective from investments, your risk-return profile, time horizon, tax liabilities, liquidity requirements, and your personal preferences.

A number of studies have shown that more than 91 per cent of the returns are determined by asset allocation and only about 9 per cent are due to other factors like security selection (Tata Elxsi vs SKF etc), market timing and other factors. Moreover, apart from return, the biggest benefit of proper asset allocation is control over risk.

The bottom line: spend most of your time in getting your asset allocation right. The guru of investments Benjamin Graham once said, "An investment operation is one, which upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."

The writer is director, Acorn Investment Advisory Services.