How financial planning differs from asset allocation?

Financial planning has picked up substantially as an essential tool for investing in the last few years. Investors are realizing that the most scientific way to reach your long term goals is to start off with a plan and then work backwards to create an investment portfolio that helps you to meet these goals. This is an important process because the success of your financial plan largely depends on the capacity and flexibility of your investment and your asset mix to ably meet these goals. To understand the process of financial planning, there is a need to distinguish between some of the subtle aspects. Let us look at the distinction between financial planning and asset allocation. While these two are closely related, there is also a sharp distinction between the two. 

The terms financial planning and asset allocation are normally used interchangeably. In fact, asset allocation is an integral and indispensable part and parcel of financial planning. The financial plan lays down the broad goals and how you want to move towards goals. It is more like a statement of intent with a broad plan backing it up. Your financial plan has facets like risk, returns, liquidity, tax efficiency etc. Apart from investment, the financial plan also looks at protection through insurance. Asset allocation, as we shall see later, is more a part of the entire financial planning process. It has more to do with the asset mix than with a broad strategy. So while the financial plan is more macro, the asset allocation is more micro. Also, the financial plan is not to be reviewed regularly while the asset allocation needs to be reviewed and assessed regularly and also rebalanced if required.

Financial Planning: the Where and What of your money

Financial planning is called the “Where” and the “What” of taking stock of your finances. There are 5 key elements to financial planning…

  • Financial planning begins with an evaluation of your current situation. This evaluation looks at what is your income, expenditure and your surplus? It also looks at what are your current assets and liabilities and what is your net worth at this point of time. This is the trigger to review whether you are saving enough since it forms the basis of your investment activity.
  • The second step is all about financial goals. For example, you may want to by a car in 3 years and an apartment in 5 years. It could also be the other way round. You may want to go on a foreign holiday after 4 years. There are the long term goals like your child’s higher education and retirement. The bottom line is that all these goals and dreams need to be assigned a financial value and then planned for.
  • Estimate the risks to the plan. Remember there are risks and uncertainties. You need to manage the risks and insure against the uncertainties. That is where insurance comes into the picture. There is the risk to life; there is risk to property and the risk to your health. These are risks that need to be insured. These expenses have the potential to make a big dent on your budget, your savings and your investment capability. You need to ensure that these risks don’t impact your goals.
  • Now you need to work out the corpus required and how much you need to invest through SIPs each month and in which asset classes. Then you need to plan your SIP in such a way that you have a high probability of reaching these goals. The idea at this stage is to tag each SIP to a goal so that you realize at all times that disturbing your SIPs means that your goals will be disturbed.
  • Finally, get down to continuous evaluation. Monitoring and evaluation will give you a clear idea of whether you are on track or not and what curative steps are required to put the financial plan back on track. These must be done so that you can act around milestones and goalposts.

Having understood the overall financial planning process, let us look in greater detail into the asset allocation, which is an integral part of financial planning.

Asset allocation is all about “How” or the execution side of the financial plan

While financial planning is the broad constitution and macro plan for your goals, it is Asset allocation that actually gets into the micros. Asset allocation is all about how to go about allocating assets so that you can reach your financial goals. Here are a few pointers …

  • Asset allocation is all not about picking up the next multi-bagger stock in the equity markets and multiplying your money. Typically, asset allocation is executed through mutual funds of different categories and also gets into specific AMCs to allocate based on set evaluative parameters.
  • Asset allocation is not about stock selection because it lays out the broad mix of asset classes. For example you need to decide your mix of equities, debt, liquidity, gold and commodities. The percentage allocation will be worked out based on the goals defined in the financial plan. 
  • The purpose of asset allocation is to optimize assets mix. That means you either maximize returns for a given level of risk or you minimize risk for a given level of returns. It is asset allocation that is constantly monitored based on factors like your goals, life stage transition, change in macros etc.

Once the asset allocation is completed then you actually get down to the task of identifying specific instruments to meet these asset allocation targets!