The difference between Financial Planning, Asset Allocation and Security Selection

The Calm Investor | Financial PlanningI get a few emails every week asking for stock recommendations. So I ask a few questions to form the context of the person’s experience with various investment vehicles, track record, their ability and willingness to take risk. In many cases, at this point, I realize the person asking for advice on stocks has little idea of their current financial situation beyond how much they make each month.

This short post will clarify and differentiate between three interlinked but distinct elements of the wealth-building process: Financial Planning and Investment Management (Asset Allocation and Security Selection).

Financial Planning: “The Where” and “The What”

Financial Planning consists of three key elements:

  1. A comprehensive evaluation of an individual/household’s current financial situation: assets, liabilities (current and potential), net worth
  2. Determination of future financial goals and their priorities classified by “needs” (kids’ education, healthcare costs for parents) and “wants” (penthouse apartment in South Mumbai, Luxury cruise around the world)
  3. Protection needed against key risks i.e. insurance (health, life, property)

You need Financial Planning if:

  • You have never taken stock of your finances and created a “personal financial balance sheet”
  • You are unsure whether you have enough and the right kind of insurance that will protect you / your dependents against catastrophic events
  • If asked, you would not be confident estimating your percentage spending versus savings, especially if you and your partner both work

Investment / Wealth Management: “The How”

After a financial plan is created taking into account “what” (current assets, liabilities and future goals), the investment strategy delivers the “how” by deciding the assets you invest in, and the specific securities within those assets.

Asset Allocation “The Broad How”

  1. Asset Allocation is the broad investment strategy drawn based on your risk tolerance, financial goals and the timeframe over which you want to achieve them
  2. The objective of asset allocation is to find the lowest risk mix of non-correlated assets that will ensure achievement of your goals

Asset Allocation tends to be the most-ignored part of the investment management process because it doesn’t feel as “sexy” as picking multi-bagger stocks. But getting your asset allocation wrong makes brilliant stock/fund picking irrelevant. Here’s why:

If you’re a 28-year-old single professional with no dependents, then a 35% return on your equity mutual fund investment combined with 6% on your debt fund could mean a total return of anywhere between 12% (20% equity fund, 80% debt fund) to 29% (80% equity fund, 20% debt fund) based on your asset allocation.

You need to focus on Asset Allocation if:

  • You have more than 6 months of living expenses sitting in your Savings Bank account
  • You are under 55 and the bulk of your savings are in Fixed Deposits
  • You have a down payment or a critical large expense coming up in the next 6 months and you’re planning to sell some stocks or mutual funds when it’s time

Security Selection “The Specific How”

  1. Security Selection is the specific implementation of your asset allocation strategy that results in your final portfolio
  2. It involves picking specific securities based on their risk-return potential in addition to their transaction costs and tax implications

You need to focus on Security Selection if:

  • You own multiple (> 3) mutual funds of the same asset class (e.g. large cap equity funds)
  • You invest directly in equities and your returns have significantly trailed the index consistently over 3 or more years
  • You switch between being an investor and a trader every few months depending on market conditions and time on your hands

The Calm Investor | Financial Planning Asset Allocation

Know where you are: Before seeking out that multi-bagger, take stock of your “personal financial balance sheet”, your goals and timelines followed by determining the asset allocation most likely to help you achieve your goals. Only then, get into deciding the specific components of your portfolio.

For the list of stock recommendations for 2018 as published by the major research houses, click here.

Further Reading:

The importance of Asset Allocation cfapubs.org

 

 

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