A Guide to Capital Allocation

Let’s go on a little nostalgia trip. Remember the cartridges or cassettes you would buy to play various video games? Super Mario Bros. was an all-time favourite and pretty much everyone's introduction to the world of console gaming.

One struggle every young gamer had was picking the games to play. The money we had would be limited, scrapped together from our little savings and gifts from relatives. The games we wanted to play, however, were countless. This led to all of us having to pick and choose what we would buy.

The process of picking the right cartridge was no child’s play, mind you. The games would always be weirdly bundled. One cartridge would have Super Mario Bros., and Adventure Island and another would have Contra, Double Dragon 2, and Circus Charlie and we could only pick one.

Sinking all our hard-collected savings was scary because there was no way to know which cartridge would be more enjoyable, and which would have the right combinations of games.

Fast forward to the present day, the general public involved in investing sinks a much larger amount of money into various instruments. They might research the instrument themself, but fail to check whether said instruments are suitable for them.

The process of selecting the right instruments for your portfolio and assigning parts of your investable capital to said instruments is known as capital allocation. Today, we take a look at how only external research is not enough and how investors also need to analyze and familiarize themselves with their financial appetites and goals for appropriate capital allocation.

Internal Assessment

Let’s get one thing right from the get-go, sirf mutual funds hi nahi, investments bhi sahi hai. It’s always a good idea to invest your savings as idle money isn’t good for a whole lot. Sure, you want to keep some liquid funds for emergencies, but that liquid fund is usually a fraction of what most people save. So what do you do with the non-emergency funds? Invest!

But as soon as one gets the idea to invest, one of the first questions that pop into our heads is, “But where?” Investment is a very diverse idea and the various instruments available are not made the same. Every instrument available in the financial market has an appropriate use case. These use cases are not just related to the instruments themselves, but also to what the investor wants to achieve with the instrument.

So the process of investment is not just limited to researching and analyzing the instruments but oneself as well. Investor needs to understand how much risk they are willing to take and the goal they wish to achieve with their investment.

Understanding Risk

When it comes to investing we’ve all heard the phrase; no risk, no reward. So by now, we know that each investment instrument comes with some type and amount of risk tied into it.

Risk can be generally bifurcated into two types; real risk and perceived risk. The real risk is the quantifiable aspect associated with an instrument. Perceived risk is the investors' take on financial adversity relative to their goals and time frame.

While the risk profile of the instrument in question definitely matters, what also matters is the investor’s risk appetite and tolerance. And yes, the two are different things. But before we talk about a person’s interaction with risk, let’s understand what risk exactly means.

In finance, a person engages in the stock market based on an assumption or expectation regarding the movement of the price or the market as a whole. If the market moves in accordance with the investor’s expectations, the investor is rewarded.

On the contrary, when the market moves adversely to the investor’s expectations, they are exposed to the phenomenon of risk. Therefore, the risk is the exposure of an investor to financial adversities that occur due to the value fluctuations that oppose the investor's view of the market.

In quantitative terms, the risk is the amount of loss or capital erosion an investor might face if they invest in an instrument and its value moves adversely to the investor’s expectations.

Risk appetite is the investor’s willingness to invest in an instrument, knowing the possibility of incurring a loss or capital erosion that is involved with said instrument. A person with a higher risk appetite would be open to investing in more risky instruments. A person with a lower risk appetite would invest in more conservative or safer instruments.

Risk tolerance is the investor's response to a change in the value of the portfolio as a result of market or price fluctuation. Investors with lower risk tolerance tend to panic buy or sell at smaller movements in their portfolios, in contrast to investors who have higher risk tolerance and stay steady and wait out minor corrections.

Your Goals

People invest for a reason. For some, it’s a better retirement; for others, it’s an international vacation, there’s a case for the education and marriage of the child/sibling, hell just “more money” is a solid plan too. Whatever the case may be, a person has an end goal in mind whenever they begin their investment journey.

Goals have the flexibility and time horizon needed to accomplish them. Based on flexibility, goals can be rigid or flexible. Rigid goals have a specific goal that needs to be accomplished within a specific time frame. Flexible goals are more accommodating to change and aren’t as mandatory.

Based on the time horizon, goals are either short-term (<5 years) or long-term (>5 years). Risk appetite, risk tolerance, and goals work together to form the ideal instrument selection for the investor that helps them achieve their goals while keeping them financially sane.

How Goals and Appetite Interact

The flexibility and time frame of the investor’s goal work together to make some investment instruments more suitable than the rest. For an investor in their 20s, a plan to retire at the age of 55 is a goal that has a long-term time frame. The goal is also relatively more flexible than say, the education of a dependant (you can retire a couple of years later, education cannot be on the back-burner).

For this retirement plan, investment in equities or equity-based funds is more appropriate. Even though equities have the greatest general risk associated with them, however for a long-term, flexible goal, the perceived risk is lower; as the losses, if any, from equities can be set off from other investments and the net effect can still be positive by the end of the investment period.

For a more rigid goal, like the education of a sibling, the time period is also short. Here, equities or equity-based funds pose a greater risk and are unsuitable for the goal. Investment in gold bonds or fixed deposits is more suitable for this goal.

A Friendly Recommendation

Ever been to a financial planning website, input your details, and found the obvious stated to you?

“You are overspending”, “You do not have sufficient funds”, “Your retirement goal cannot be calculated”... No kidding! We know we have money troubles. That’s why we visit these websites, not to have our problems retold to us, but to find a solution to them.

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So head on over and get to cooking a plan for financial well-being on Finology’s Recipe.

The Bottom Line

As is always said and very obvious, there’s no pre-made, ready-to-go financial advice that fits everyone. Just like the fingers of our hands, no two people are made financially equal. So their needs and preferences will vary too.

What helps every investor is knowledge, not just of external factors like stock market behaviour, prices, etc. But knowledge of the investor that each and every person is.

That’s it for today. Tata now.