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Financial Pyramid - Asset Classes

Updated: Sep 6, 2020

This is the third article in the series which gives Finsights on money management. The first article explains the need to save money and the second article equips you on how to determine your financial health. In this article, we will explore the Financial Pyramid to help you understand where you are positioned in investing under asset classes and how to diversify your asset allocation based on your position in the pyramid.


The direct outcome of accessing your financial health is identifying your strengths and weaknesses and taking appropriate action to improve your financial health. Understanding where you are in the financial pyramid will make it easier to identify where you need to focus to stabilise or consolidate your financial strength. If you are losing money, you need to stabilise. If you are not losing money, but the surplus money is not growing efficiently, you need to consolidate.


So what is the financial pyramid? It's defined in various ways across financial literature, here we will define it based on asset category and capacity to invest in that category.


A classification of different financial asset classes
Financial Pyramid

There are 5 classes in the pyramid and we will explore them bottom-up.


1. Liquid Assets

These are cash that you hold at home/wallet, money in your saving bank account. You just need enough money to meet daily expenses. Probably the money required for 6 months of expenses under the current situation of COVID should be allocated. For normal situations, 3 months worth money is sufficient. Too much allocation to liquid assets means you are not making the money work for you by generating better returns than what you get from a savings account. Too less means you are risking a shortage of money due to emergencies. It does not matter if you are generating return on this money, it is just the ready availability that matters.


Anything beyond the liquid assets is invest-able money.


2. Low Risk Assets

When you have surplus money after allocating liquid assets, you need to start investing in low risk assets such as Fixed deposits, Public Provident Fund, Voluntary Provident Fund, Govt Savings Bonds etc. This will insure that you are building a low risk, low return fund that can help you generate enough corpus to live through post retirement. Note that this money is for post retirement only. Your lifestyle expenses should be funded by your income. Do not liquidate this money to spend for luxury. Generally, the returns of these asset classes just about meets the inflation rate after all applicable taxes. Hence you are risking a peaceful life after retirement, if you are not saving enough under low risk assets or liquidating this asset to fund your lifestyle.


Risk is unavoidable in any financial asset type. FDs might feel safe, but still even that carries a degree of risk, even though it is far far lesser. Take the example of deposits of YES Bank. The bank went into crisis and luckily the Government backed up and kept the bank afloat, otherwise, the depositors would have had a tough time in getting back their money. Yet, you can minimize even this risk by distributing your deposits across different banks, both public and private. Always diversify across assets and within assets.


Diversification is the best and easiest risk management strategy.


3. High Risk Assets

High risk assets help you generate better returns than FDs, PPF, VPF etc, but as the name states, there is a higher degree of risk involved. Direct equity investments, Mutual Funds, National Pension Scheme(NPS) with high exposure to equity, Corporate Bonds etc., are common examples of high risk assets. When we talk about risk, do not misinterpret that the risk is on the return. The risk is on your Capital. It’s a common misconception that people perceive the risk of low returns instead of losing capital. People get shocked on seeing negative returns on bad investments, which is actually an erosion of capital. By perceiving the risk correctly, you should invest only the money which you can risk, meaning, you do not have any short/medium term commitment that is dependent on this money. The returns are expected to beat inflation convincingly so that this money can either be used to build your retirement corpus or fund lifestyle expenditures.


That said, the returns that are being currently generated by Mutual funds with equity exposure are all negative over 1-3 year periods. Everybody who has invested in these schemes over the past 2 years have seen severe cuts on their capital, but it's not limited to the recent investors alone. Investors who are in the market for much longer duration have also seen cuts in their returns. So how do you mitigate this situation? A general “advice” that you would get from a MF/Stock Broker is to stay invested and keep pouring money via SIPs. In my opinion, that is not ideal. You should take time to revisit your portfolio and take profits off the table from time to time and reinvest when the time is ripe. This way you would safeguard your capital, there by increasing your risk taking capacity over a longer period by reinvestment. The returns are much better when you manage your portfolio actively instead of contributing to SIPs passively. Keep churning your portfolio to avoid mishaps. The market always moves in cycles, there are periods of economic boom followed by bust.


Being invested during periods of bust leaves you one step backward after being two steps forward.

You could also diversify within the asset class by allocating to safer debt funds. During economic turmoil and RBI interest rate cut cycles, debt funds perform better than equity funds, so it makes sense to switch allocation based on the market cycle.



4. Alternative Assets

As your risk appetite grows and you have a significant healthy portfolio built under the high risk asset class, you could consider exploring alternative assets. Though it is not mandatory to expand your asset allocation to this category, this helps in diversification. Some examples are Equity Derivatives(Futures & Options), Cryptocurrencies(Bitcoin, Ripple, Ethereum etc). Especially during buoyant economic periods, people who are unsatisfied with the returns of traditional investment themes explore these alternative assets for diversification and also for generating superior returns. Needless to say, the regulatory norms for these assets could be troublesome and along with it, the risk is higher than the high risk assets themselves. For this reason, the investors should be abundantly cautious and clear on what to expect out of this asset and is not recommended for a casual investor.


Alternative Assets are for sophisticated investors.


5. Venture Capital

Venture capital is the money with which you start a business. These are usually Private Equity investors or promoters who fund startups or take significant stake in established companies. Alternatively you can start your own business too. As a salaried commoner, not many would even have the need to explore this avenue. This asset class carries the most risk and if you have so much money invested across all other asset classes that you do not know what else to do, then it's time to own a business rather than to invest in a business. But if you are an entrepreneur, this is your bread and butter. The returns, if the business model becomes a success will be phenomenal, unmatched by any other asset class. But if the business goes bust, you lose most of the money.


Go for it, if you need to be on a company's board!

Since we are focusing on investment plans of non-entrepreneurial individuals, this might not be applicable to many. But if I have underestimated you, please pardon me and let me know when you are floating an IPO, so that I can have some preferential allotment of shares in your company :-)



Property, Gold & Commodities

This is a special mention. Note that, I have not mentioned property and gold under any asset class. Property is a liability and not an investment due to the fact that the returns are so minuscule compared to the capital involved. You are better off putting that money in a fixed deposit, unless you do not own the roof over your head or you are into real estate business. At best, it can be considered as a safety or leverage for your debts. More importantly, it is not easy to liquidate this asset which makes it a liability.


Gold is the same as equity in my opinion. Both Equity and Gold have good returns over really long term, but it is susceptible to short term price fluctuations. Though it is considered a safe and evergreen investment, I am sceptical. Every family has invested in Gold, it is a very common asset. And what do we know about items that everybody owns and is abundant? It is not valued, but for some reason gold is always valued. If the global economy collapses for some reason and when people try to liquidate gold, the market will be flooded with gold and who would be ready to pay so much money when the market is flooded? None.

We do not know when the Gold bubble will collapse, making it the same as Equity.


The only asset that survives a global economy collapse is Commodities. Think about it!

 

All this is fine, but how do you know how much money should be allocated to each asset class? Well, that’s a really tough question and to a great extent, we cannot give a common asset allocation rule for everybody because it depends on each person’s income, commitments & risk profile. But I am trying to stitch together an idea of how you can approach your asset allocation plan in my next article. Until then, stay safe and Get Finsight!



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