Sample Financial plan #6 – Asset classes and their role

Before we get into creating an actual investment plan for Ravi and Madhuri, we need to understand the concept of asset classes. As you know an Asset is something that has monetary value and can be sold or exchanged. Asset class is an aggregation of similar types of assets. Instead of trying to go for a complex definition, let me give some pointers:-

  • Typical asset classes are Cash, Debt , Equity , Gold, Commodity, Real estate etc
  • FD, RD, Gilt funds, Other debt MF are examples of the asset class Debt.
  • Stocks, Equity based MF are examples of the asset class Equity.
  • Mutual fund is an investment vehicle belonging to the asset class Debt or Equity.
  • A specific stock or a specific MF scheme is an example of an investment product.

From the above, you will understand that our investment plan will comprise multiple asset classes, vehicles and products. This helps in diversification and also reduces risk to a great extent. But, how do you know which asset class is appropriate for you? We can evaluate all asset classes by the following characteristics:-

  1. Risk: This can be defined as the probability of losing your principal amount that has been invested. This will be highest for Equity and lowest for Debt with the others in between.
  2. Return: This can be defined as CAGR obtained by investing in the asset class. Over the years Equity and Real estate have given the highest return. However, the volatality in Equity returns is also significantly more. Debt will typically have much lower returns but these will be stable with limited volatility.
  3. Liquidity: This can be defined as the ease with which you are able to redeem your asset if needed. Equity is normally the ,ost liquid and Real estate is the least liquid of the asset classes.
  4. Tax Treatment: This can be defined as the need of paying tax when you redeem the asset. In India Long Term Capital Gains are tax free for Equity. Different Debt instruments have different tax treatments, FD s are fully taxable.

Ideally you would like to have an asset that is risk free, tax free, highly liquid and has great returns !! Unfortunately, such a scenario is Utopian, and therefore we need to create a suitable asset mix for our financial and investment plans. In general, for a goal that is far away one would like to have an asset which grows the most even when it is volatile at times – Equity fits the bill well here. For shorter time duration Debt will be more appropriate.

We will be using the learning from this post when we get back to Ravi and Madhuri for making their investment plan. In the next post though we will look at their risk profiles and determine which asset classes are they comfortable with.


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