Retirement planning – III

I have written earlier on retirement planning here and here. There were several comments on both the posts and so I have decided to start this post with a Q&A

Q1: I think gold/ commodity (put any asset you like) is good and I do not agree with your point that one should avoid it

My response: If you know what you are doing and have the knowledge and the skill to invest, then please go for it. My specific point is that if you are a know nothing or a newbie in these asset classes, then play around a bit with small amounts of money till you get a hang of it. The market will not forgive you for your ignorance.

Q2: Are the asset allocation percentages fixed. Should one not vary them based on market condition?

My response: Asset allocations are not set in stone. However one should remember that asset allocation will play a big role in determining the return on your portfolio. So one should fix the asset allocation based on one’s risk tolerance. Translation of this mumbo jumbo – In my own case, I will only invest as much in equity in which I can tolerate a 50% temporary drop. As a matter of fact, the market dropped by almost 50% last year and most of us got a taste of how much drop we could tolerate without losing sleep.

Q3: There is no mention of insurance, ULIP and other hybrid schemes

My response: Pure risk insurance is important and one should always have an adequate insurance cover (more on that in another post). However I completely and totally hate ULIP and such unit linked plans. They are a complete rip off and one should stay away from them.

In my own case, I said no to a close relative who was pushing this kind of scheme. I told him that I will give you the incentive you get from the company for free as long as I don’t have to buy the scheme from you (that way he benefits and I don’t lose money for the next 20 years). You can guess how happy he is with me J .

Please do not invest in such schemes unless you have analyzed them in detail. It is far better to buy the insurance and the fixed income/ equity piece separately than bundling it via unit link schemes, pay the high commissions and expense loads and lock the money for a long period of time.

Asset allocation and rebalancing
I have written about how asset allocation drives you portfolio returns. All of us think we can tolerate risk and can afford to have a high equity component. My suggestion is to keep it lower than the level you think you can maintain without losing sleep.

Let’s say you are looking at 11-13% returns and are planning to keep around 50-55% of your portfolio in equity. I would suggest that one should start with a 30-35% allocation and go through a bear market and see how one is able to survive it. If you are able to avoid the gloom and doom and still able to invest during the bear, then go ahead and start raising the allocation. It is easy to maintain a high equity allocation during a bull market. We are all geniuses during bull runs. The test of patience and risk tolerance is during a bear market.

Finally if one is not actively managing his or her investment, then it makes sense to start reducing the equity holdings during a bull run to bring it to the target allocation. For example, if you target is 40% and the equity components goes up during the bull market to 60% of your portfolio, then it makes sense to start liquidating some equities to bring it to around 40%. In contrast, if your allocation drops to 30% during the bear market, then one should start buying equity to bring it up to the target level.

The above suggestion is easy to understand and very difficult to execute. I have personally gone through this last year. It felt like quick sand. I was constantly adding money from March 2008 to my equity portfolio and the market kept dropping at the same time. So at the end of the year, the absolute value of the equity portfolio stood at the same level as the start of the year, inspite of pouring money into it. It is not easy to constantly lose money in face of a bear market.

One can further split the allocation between different instruments in each of the categories. One can split the debt component into Bank FDs, Debt funds, Post office deposits etc. In a similar manner the equity component can be split between mutual funds and shares. The actual numbers need not be precise and you do not have to get very scientific on it. As long as you are close to your target levels, it should work out fine.

Administrative effort
This is an ignored, but important component of portfolio planning. It does not make sense to invest in an option where there is a lot of documentation and other risks and costs involved. In the past, shares could be bought and sold only in the physical format and there was always a risk of bogus shares and the headache of paperwork.

In a similar manner mutual fund investing also involved a decent amount of paperwork. Luckily most investment options (except Post office schemes and Bank FDs like that of SBI) are now convenient and easy to manage. However one should keep in mind the paperwork involved in the specific investment option. My own preference is to look for option which requires minimal paperwork, allows online mode of investing – preferably automated, and does not require me to track payments and receipts on an ongoing basis. I also prefer investment options which would allow me to pull an electronic statement at the end of the year for tax purposes.

Most of the investment options and firm providing them are focused on making it smoother and easier for the investor. However we still have some options such as the post office and public sector banks which believe in torturing you, even when they take your money.

Scratched the surface
The entire topic of retirement planning which is a subset of personal finance is a vast topic. One could write a book on it and could easily update it on an annual basis. I have tried to scratch the surface here and just provide some initial thoughts or factors to look at when developing your portfolio for your or your parent’s retirement.

If you have to take one point from my posts, it should be this – Invest with full knowledge and understanding of the investment option and always focus on the risk or downside.

Please feel free to leave me any questions on the above topic in the comments section and I will be glad to answer them.