This question is really asking how you would allocate N1 million amongst different asset classes. But before we consider that, let us start from the basics.
What are asset classes?
Asset classes are securities that exhibit the same characteristics. For instance, Fixed Income as an asset class, will include all financial instruments that pay fixed returns. They will range from “risk free” securities like Sovereign Bonds, to risky junk Bonds issued by the private sector. Look at asset classes as cars that take you to an investment destination.
Variable income as an asset class group will include all financial instruments whose return are not fixed, but variable in nature. These asset classes range from Equities, to include Real Estate Investment Trust (REITS), and even Derivatives.
Rule of thumb, Fixed Income Assets are less risky than variable income stock.
So, how would you allocate N1 million?
Well, it depends on:
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- your age,
- how much risk you are willing to take, and
- how long you want to wait before you need your principal.
To be clear, we are investing, not saving. What is the difference? Saving is simply the act of putting money away, while investing is the act of putting away money with a specific objective in mind, and the expectation of a return. When you invest, you expect a return.
First consideration: how old are you?
Age is a very important factor because the younger you are, the more risk you can take. Why? If you are younger and you lose all your investment capital, you have a better chance of starting over and replacing lost income. Also on a positive note, age in finance means more compounding periods i.e., age means that your investments have more opportunities for earning to be ploughed back to grow.
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If you are younger, you should invest more in variable income securities like shares, because over time they offer greater chances of higher returns, but with a higher risk. If you are nearing retirement, then you should not under any circumstance invest more than 20% in variable income securities like shares, no matter the return potential.
Second consideration: What are your objectives?
If your investment objective is to grow your investment capital with a Capital Appreciation Goal, then you want to invest in variable income asset classes like shares. This is because variable income securities have a higher propensity to beat inflation than fixed income securities. Keep in mind that more variable investment means more risk.
If, however, your objective is to protect your principal from loss with a Capital Preservation goal, then you should invest in fixed income. The risk here is that your returns may not beat inflation.
Last Consideration: How long do you have to stay invested?
If you have a long investment horizon, meaning if you can keep your investment capital in the financial market without seeking it back in more than five years, then you want to stay in variable income; specifically equities. This is because equities as an asset class have a high propensity to beat inflation.
However, if your will want your investment capital back in say less than 24 months, it is advisable you invest in fixed income because you can determine exactly how much you will get back in 24 months.
Let us look at scenarios:
- Recently-employed 21-year old Ade, was gifted N1 million by his rich aunty. He wants to save this to fund his wedding in 10 years. How should he deploy this fund?
- 70% in Variable Income, specifically mid and large capitalization stock
- 20% in Fixed Income, specifically 2yr Saving Bond
- 10% in Cash as Money on Call with a Bank
- Objective is long term capital appreciation.
- He may need cash before 10 years, so I invested 20% in safe government bonds payable every 24 months. This is also diversification to protect the portfolio.
- He may need good old cash to buy his engagement ring, we put 10% in a bank to prevent breaking any invested principal before maturity.
2. Okoro, 64, about to retire, received N1m as gratuity advance payment. How should he deploy this?
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1. 80% in Federal Government Bonds. However, we will “ladder the investments as below:
a. N200,000 in 2-year bonds
b. N200,000 in 3-year bonds
c. N200,000 in 4-year bonds
d. N200,000 in 5-year bonds
2. 20% on “call” in a bank?
2. He is a retiree; investment objective is capital preservation. He has zero risk capacity. Variable income is a no-go area. However, even within fixed income we have done tactical asset allocation within the fixed income asset class.
3. We have “laddered” his investment so that his principal investment comes due every year for the next 5 years. This allows flexibility to invest if rates rise, but also carry the risk that if rates fall, he is not locked.
4. 20% as cash in a call account ensures that he has cash for emergencies and does not break his tenured investment
These case studies have picked both extremes of investors. You may find yourself with similar objectives as either examples, e.g., low risk profile but seeking capital appreciation, which then means that you need a balanced portfolio.
Whatever you do decide, keep in mind that when choosing where and how to invest, you must consider the variables of:
1. Your age
2. Your investment objectives
3. Your risk profile