1) Confusing asset allocation with diversification
Investors tend to use the terms interchangeably. Often they pack their portfolio with 15 to 20 funds and believe have achieved both.
Asset allocation is the process of determining the right mix of investments you should own. In other words, how much of an exposure you need to have to various asset classes.
At the most fundamental level, they are equity, debt and cash. It can further be built up by looking at other asset classes such as gold, commodities, real estate, art, private equity and collectibles.
Whatever your situation or life stage, having the right mix of investments is crucial and can increase returns and reduce risk.
Diversification is what you invest in within these asset classes. For instance, you may decide to allocate 65 per cent of your portfolio to equity. Figuring out how to invest your money within this asset class is where diversification comes into play.
This would entail deciding on the number of equity managed funds to hold — the mix between growth, value, infrastructure or other sector funds; how many large and mid-cap funds; as well as whether or not to have an international fund to gain global equity exposure.
Asset allocation maximises the risk-adjusted return and reduces risk by combining asset classes that have less-than-perfect correlations. Diversification reduces the investment-specific risk.
2) Overestimating the level of diversification
There is a fine line between the two that is often crossed. While diversification reduces risk, over-diversification may do so at the expense of outperformance.
For one, do not be under the misconception that you are a slacker unless your portfolio is packed with plenty of funds and stocks. You need to be an investor in funds and stocks, not a collector.
When individuals keep investing in new fund offerings and the current year's topper, they find that over-diversification unwittingly sneaks up on them and is rarely a deliberate move on their part.
3) Refusing to rebalance
The entire purpose of asset allocation will be lost if you refuse to rebalance. Rebalancing is the process of restoring your portfolio to your target allocation for it.
You don't have to do anything to your portfolio for it to change. That's because some of your investments will do particularly well while others won't. (That was the whole point of maintaining an asset allocation in the first place).
Those investments that have done well will naturally begin to take up more of your portfolio. Those that haven't done as well will take up less of your portfolio.
But every so often, you need to readjust your portfolio, to restore its original balance. If your investment goal hasn't changed, your portfolio's mix shouldn't, either. Because of market forces, however, it does.
At the start of January 2008, if you had rebalanced your portfolio, you would not have lost half as much during that year.
If you find that your stock portfolio has done exceedingly well, you could book profits in some of your holdings to restore the equity/debt ratio or you could leave your equity holdings and buy more debt to restore the balance. Trim your winners and feed the laggards.
4) Not investing internationally
India represents around 3 per cent of the world's stock-market capitalisation. Diversifying globally opens the doors to an immensely greater set of investment opportunities.
There are excellent companies across a broad swathe of industries with very mature management and growth opportunities.
Not only does global investing give an exposure to another market and currency, but also to stocks which are not available in India. You enjoy your Coke, are hooked onto the coffee at Starbucks and swear by your Dell laptop. Then why not invest in these stocks?
As is the case with stocks, so is the case with sectors. To meaningfully participate in industries like e-commerce, mining, semiconductors, casinos and online gaming, investors are forced to look outside India.
5) Not keeping cash
Every adviser will tell you that no matter how meticulous you have been in your financial planning, the unexpected can happen. It could take the form of a job loss, a sudden and significant medical expense, or an unexpected house repair.
Such situations are stressful and can prove detrimental to your savings goals because it forces you to draw money out from your current investments and retirement kitty. But much of the damage can be minimised by maintaining an emergency fund.
You don't need to keep it literally in cash at home. You can consider a mix of a savings account, a liquid or short-term debt fund, or a flexi-deposit that banks offer. The latter will give you a rate of interest higher than the savings account but provide you with the liquidity.
Saving for a rainy day is a very good idea. If you don't, you are that much more vulnerable to sudden life changes.