Importance of asset allocation

Raghuram V, a 29-year-old IT consultant was not too comfortable with the way his portfolio looked at the end of November 2008. Given the steep market correction from the beginning of this year, his equity holding had fallen sharply. As a result, he wanted some advice on how best he could re-align his portfolio to recoup some of his losses.

The table on the left clearly indicates the losses suffered by him between January 1, 2008 and November 30, 2008. A quick glance will show that Raghuram's investments in equity and equity mutual funds were hit the hardest.

While his direct equity investments dwindled from Rs 5,69,879 in January to Rs 1,59,566 in November his mutual fund investments came down from Rs 8,63,259 from the start of this year to Rs 3,28,038.

Overall, his portfolio shrunk considerably by Rs 9.41 lakh. The equity exposure through direct equity shares and equity mutual funds fell from about 80 per cent (Table 1) in January to the current level of 57 per cent (Table 2) because of the steep market fall.

The ULIP was the only form of life insurance cover that he held with a sum assured of about Rs 6 lakh. The fund value as of November 30, 2008 was Rs 1.26 lakh. While he was drawing a salary of about Rs 8.4 lakh per annum he held cash of Rs 2 lakh in his savings bank account to meet any emergency situations.

Because his parents were old and prone to health problems he consistently maintained a minimum of around Rs 2 lakh in his savings bank account. Any additional cash required would have to be brought in from his investments (more so equities).

The table below shows how Raghuram's priorities were placed: He needed Rs 7 lakh to take care of his child's education by 2024; another Rs 50 lakh to construct / buy a house for himself; Rs 40,000 per month as pension after he completed 50 years and money to meet any medical emergencies that his parents might face.

Out of his monthly surplus of Rs 25,000, he set aside Rs 5,000 every month towards the ULIP. While he was averse to combining insurance with investments he did it at the behest of his friend, mainly for tax saving. He had systematic investment plans, SIP, into equity mutual funds running to the extent of Rs 10,000 per month. The balance of his savings (Rs 10,000) was invested into equities whenever he found an opportunity.

Apart from his investments he also felt the need to cover his parents against health hazards because of rapidly increasing health expenses. He wanted to fund the education of his son who was a little under two years and planned to invest in a house worth Rs 50 lakh in a couple of years. He would then save on the rent of Rs 14,000 per month that he is currently paying.

Recommendations: What he should do

After looking at the overall picture we first did a review of his current investments and found them to be pretty equity-focused. In November 2008, Raghuram held a set of 22 mutual funds with about 78 per cent exposure towards mid cap and sector funds.

He also had good number of new fund offers since he felt they were coming cheap at Rs 10, a common mistake that investors make. Finally, we realised there was an immediate need to re-align and consolidate Raghuram's equity mutual fund portfolio because over-diversification (putting money into too many mutual funds and stocks) was dangerous!

Within his equity mutual fund portfolio we suggested he consolidate his investments across six mutual fund houses including HDFC, Templeton, Reliance, Birla Sunlife, Sundaram and DSP Blackrock over about eight equity schemes, with a combination of large cap / mid cap / theme / contrarian funds. The funds were chosen based on factors including long term track record, performance on market falls, the fund manager and requirement to diversify across investment styles and market caps.

The weightage of mid caps was recommended to be reduced significantly for the next two years (in a steep market fall mid caps fall the most). Equity shares also need to be consolidated within a set of large cap and mid cap stocks, preferably, with a greater bias towards large cap companies (they recover first when market move up).

Considering that his parents were within the insurable age, a family floater health cover of about Rs 5 lakh to Rs 8 lakh was suggested reducing the need to hold cash in his savings bank. For emergency purposes, we suggested holding three months' expenses in the bank account and move the rest into debt mutual funds: preferably into Liquid Plus (a debt mutual fund scheme that is easy to buy and sell) and short term gilt funds. Gilt funds invest purely in government securities and hence are safe. Debt mutual funds were preferred over bank fixed deposits considering that he was in the highest tax slab.

The premiums paid towards parents' medical insurance would also qualify for deduction US 80D to a maximum extent of Rs 15,000.

A house for Mr Raghuram

For the house that Raghuram wanted to purchase by 2010, we suggested he use a loan of Rs 40 lakh; the balance of Rs 10 lakh could be brought in as down payment. As this need was likely to arise in the medium term, we could use part of the investments in ULIPs, bank fixed deposits and equity mutual funds towards this need.

We suggested a continued contribution towards the ULIP, since they are beneficial only in the longer term. The equated monthly installment (EMI) paid towards housing loan will help avail of tax benefits on interest as well as the principal part as deduction US 80C. In addition, Raghuram could save on rent (Rs 14,000 per month now) assumed to be about Rs 15,000 per month in 2010.

After a detailed study of his monthly expenses, needs and current insurance cover, it was estimated that an additional cover of Rs 75 lakh was required. Given his age, we suggested that he avail a term cover for a period of 25 to 30 years that would cost him about Rs 22,000 to Rs 25,000 per annum depending on whether he chose a 25 or 30 year term and the company he chose. The term insurance cover provides only risk cover and no returns. The premiums paid towards such term cover would also cater to deduction US 80C.

In the whole bargain of planning for his needs, we had particularly taken care of his deductions US 80C and 80D.

Meeting Raghuram's targets

For his monthly investment, we suggested him to use SIPs into equity mutual funds for Rs 10,000 per month. We suggested he invest Rs 2,500 per month in gold ETFs or a fund investing in gold mining companies.

Rs 2,500 monthly could be invested into a bank recurring deposit or a debt mutual fund. Considering that interest rates are likely to start seeing a downward cycle (decrease from current levels), income funds were the preferred option of debt funds. Such funds offer monthly returns and are easy to sell if the need arises.

We suggested Raghuram continue with his ULIP investment because such plans give good returns only over a period of 15-20 years.

Considering his age, the target asset allocation had a reasonable tilt towards equity (both directly through stocks and indirectly through mutual funds). This was also aided by the SIPs that he was investing in. The objective was to have a balanced portfolio across various assets.

Now that we have made a plan for Raghuram to recoup some of his losses it is important he sticks to it. While asset allocation helps optimise your returns and stay well within the preferred risk profile, regular monitoring will help best achieve the required financial goals and create wealth in the medium to long term.