Financial planning is designed to help individuals develop sensible investing habits. Everybody has different risk appetites and financial needs also change with age. A good financial plan encourages habits that take these factors into account.
Most plans start with two axioms. One is that it is necessary to save and invest continuously and mechanically. The second is that a diversified basket of investments will be safer than a concentration on one asset-class.
Financial planning is geared to meet "normal" goals. If you aim to turn a corpus of, say, Rs 1 lakh into Rs 1 crore in the next year, you will have to find high-risk assets. No financial plan can help. Normal plans also cannot easily cater to people with extraordinary gifts and unusual income streams. A sportsperson, for instance, might earn the bulk of her income between 20 and 35 years. An artist, lawyer, or author could make far more money at 75 than at 50. An entrepreneur can hit millionaire status with one asset - her business - being 99 per cent of total net worth.
Most people's incomes peak in the 50s-60s decade, after which financial needs increase, while incomes plateau or fall. Most plans involve switching to safer assets as one ages. A young person with many decades of working life can take risks. An older person should hold more stable assets like debt.
The simplest benchmark of life-cycle investing is the "subtract from 100" rule: Subtract your age from 100 and you have a rough idea of how much you should invest in equity and other risky assets. This age-equation is only a guide. If you have a high tolerance for risk, you may increase equity exposure and vice versa; if you have low risk-tolerance, you may decrease it.
If you're 25, you should park somewhere around 75 per cent of your savings in equity and other risky assets. If you're 50, you should park 50 per cent of your savings in equity. The rest of the portfolio should be allocated to safer assets with lower returns.
It sounds sensible in theory. What are the practical difficulties? First, equity can give negative returns over long periods of time. The middle-aged person has a problem if there is a prolonged bear market in force at the time when he is supposed to liquidate equity assets and switch to debt. How long should he wait for the market to recover?
Second, how often should one rebalance? Let's say a 25-year-old investor allocates 75 per cent of savings to equity. It is a bull market. A year later, the equity portfolio is worth 90 per cent of his total assets. Should he rebalance by moving 15 per cent of assets out of equity?
The opposite problem could occur in a bear market. The equity proportion might drop sharply if there's a bad year. In that case, should the investor move other assets into equity to rebalance? Or, should the investor mechanically rebalance every three years or every five years, ignoring fluctuations in between?
The argument for frequent rebalancing is that the risk profile changes as different assets grow at different rates. A portfolio very heavily overweight in equity is more dangerous than one less overweight. The argument against frequent rebalancing is that it leads to over-trading and might not give the equity component enough time to ride out inherent volatility.
By the way, every rebalancing inevitably involves taking a "view". It is humanly impossible not to be influenced by the past performance of assets, or to have future expectations and projections. The investor must take care not to let such considerations warp objectivity.
Rebalancing and coping with big fluctuations are important decisions. These must be made by the individual. There are no guarantees. Any given answer could be correct, or disastrously wrong. Financial planning is not a magic bullet. It helps inculcate disciplined investing and saving habits which should lead to superior returns. But you could follow a financial plan diligently and logically and still end up with poor returns if you make a few mistaken decisions at critical junctures.
