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The difference between financial planning and asset allocation

The terms financial planning and asset allocation are normally used interchangeably. Actually asset allocation is a part of financial planning. The financial plan lays down the broad goals and how you want to move towards it. Your financial plan has various facets like risk, returns, liquidity, tax efficiency etc. It also includes protection through insurance where you actually protect yourself against exigencies that are unknown and uncertain. It is also essential to understand the role of asset allocation in financial planning as well as the importance of asset allocation in financial planning. But first the concepts!


What do we understand by financial planning?
Financial planning is called the “Where” and the “What” of taking stock of your finances. Before we understand the “Where” and the “What”, let us lay out the key elements of financial planning. In fact, there are 5 key elements to financial planning..

It begins with a comprehensive evaluation of your current situation. 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 helps you take stock of where you stand today financially.

The second step is where you want to reach. This is all about financial goals. You may want to by a car in 2 years and an apartment in 5 years. You need to plan for that. You may want to go on a foreign holiday after 3 years and that also requires planning. Then there are the long term goals. You may want to set aside a corpus for your child’s higher education. That is a big investment nowadays. You may also want to plan for your retirement at the end of 25 or 30 years.

The third step is to work backwards and estimate the risks to the plan. 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. You do not want these expenses to make a big dent on your budget. You need adequate insurance to ensure that your family is taken care of in your absence and that your long term goals are not impacted.

Then the real job begins. Once you are convinced that your risks to the plan are taken care of, you need to work backwards. You need to work how much you will need and then calculate the present value of these goals. Then you need to plan your SIP in such a way that you have a high probability of reaching these goals. This step will actually form the basis of your asset allocation which we will deal in much greater detail later.

Finally, you must a sensitivity analysis which will become the basis for monitoring your financial plan. Your plan must be constantly evaluated and monitored based on some specific parameters. This 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 given steps actually cover the entire gamut of your financial plan. Asset allocation is a part of this process, which we shall deal in greater detail.


The “How” of Asset Allocation
Financial planning is the complete Where and What of your finances. It lays out where you want to reach and what you need to do about it. That is still a macro approach. Asset allocation is all about getting into the micros. How do you go about allocating assets so that you can reach your financial goals; that is what asset allocation is all about! Here is what you must know about asset allocation..

In case you believe that asset allocation is all about picking up that next multi-bagger stock, sorry that is not asset allocation. In financial planning you do not get into asset specifics. Ideally, you plan through equity mutual funds which are relatively passive compared to direct equities. So what does asset allocation cover?

Asset allocation actually lays out your 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 backward based on the goals defined in the financial plan.

Asset allocation is not only about returns but also about risk, tax efficiency and liquidity considerations. 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.

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

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