Allocating Diverse Asset Classes Equally Doesn’t Guarantee Success

When it comes to investing, there are four major asset classes: Equity, Debt, Commodity and Real Estate. The often followed approach is to allocate equal proportions in each asset class. However, each asset class has its own pros and cons. To get a better understanding on how to go about allocation, it is important that we understand the pros and cons of each asset class well.

Asset Classes: Pros & Cons Debt: This refers to investments which offer guaranteed returns. Here, an investor will receive the interest decided at the time of investment. People often are charmed by the prospect of “guaranteed returns”. What they overlook is the opportunity cost of such an investment over the long term. A practical approach here is to have enough debt investment to cover six months’ worth of household expense and any other short term expense that is foreseen. The benefit of this asset class is that it is highly liquid whereas the con is that it hardly beats inflation.

Commodity: This refers to tangible commodities like gold or silver which can be exchanged for cash or products of similar value. The benefits of this asset class is that it is a global currency since many centuries. People often tend to purchase the dematerialized form of this asset class which dissolves the entire significance of this asset class. Let understand this with an example. Suppose a war or a natural calamity strikes a country and people are forced to flee and take refuge in another country, at such times, only this asset class is useful in tangible form. Hence, it is advisable to hold this commodity in physical form such that one can survive for at least a year or two. The con here is the risk of theft and negligible returns compared to other asset classes.

Real Estate: This refers to property consisting of land or building/house. People often forget that this asset class is only for consumption and not investment. The pro here is that it gives an individual a sense of ownership/belonging. The con - it is the least liquid asset class, involves huge transaction cost and is tough to liquidate/sell. This is reason why most of the large companies/banks opt to lease the property as they believe that paying rent is an asset and the capital money which is saved by paying rent can be used for expanding the business.

Equity: This refers to partnering with multiple companies by way of investing in the company shares. The general myth attached to equities is that this asset class is risky in nature. However, the reality is that equities is volatile in the short term but delivered encouraging returns over the long term. As Benjamin Graham said, “In the short run, the market is a voting machine but in long run, it is a weighing machine”

Historical data shows that over the long run, equities tend to deliver the highest return, has the highest liquidity, is tax efficient and delivers risk and inflation adjusted returns. If an investor’s investment horizon is longer than five years, then equity is the asset class to be in as it has the potential to deliver sizable returns especially in a growing economy like India. Also, one can effectively further diversify within this asset class by way of market capitalization and sectors.

Now that we know the pros and cons of each of these asset classes, you would have realized that investing equal proportions in all the four asset classes is a flawed idea. It is better to seek the help of a financial advisor who after understanding your life stage, occupation, lifestyle, financial goals, investment horizon etc. will help put together a portfolio which will help meet one’s financial requirements at varying stages of one’s life. Also, the allocation to various asset classes will be decided in the light of these details.

Hence, we say, the term Do Not Keep All Eggs in One Basket and divide it equally among various asset class is widely misunderstood.

Anjali & Nitin Patel, Director & Managing Director, Finfreedom33 LLP

Disclaimer

The views are personal and are not part of the Outlook Money editorial Feature.