There’s something strange about the way the process of choosing investments often begins. When a saver wants to know where to invest, the worst question to start with is the obvious one: “Which investment should I choose?”
What I’m saying sounds paradoxical—after all, if you want to make the right choice of say, a mutual fund, then you’ll have to ask which one, right? How else would you choose? However, if that’s the question then there’s practically no chance of getting the right answer. And sure enough, the way investments are sold, this question is presented as the first and the most important one to ask.
However, it’s the wrong one. The right question to ask first is: “What type of investment should I choose?” The reason for this is that choosing an investment is not a bottomup activity but a top-down one. The process of deciding how to invest your money consists of layers of decisions. At the top (first) layer, one has to figure out the general mix of asset classes such as equity, fixed income, real estate and such. This mix depends on your time-frame, risk-taking ability, need for income, age and such broad parameters. Only when these issues are understood and the decisions taken, does the stage of choosing the actual investments arrive.
At the next layer, you need to decide what kind of investments should make up each of these. At that point, the kind of questions to be answered are, for example, should the equity investments be equity mutual funds or direct investment in equity? Should the fixed-income investments be a bank FD or a post office deposit or a liquid fund? In fact, the decisions you take at this layer may even be driven by convenience and knowledge rather than by your needs.
Note that the original question, which I denounced as being inappropriate as a starter, has not been asked even at this second layer. It’s turn comes only at the next layer, when you decide the actual investment that the money goes into, such as which fund or which stock and so on.
If you find yourself doubting the logic of what I’m suggesting, then think through the investing process as it would be if you start with the wrong question. If you actually should not be investing in equities, then what good does it do if you end up choosing the best possible equity fund? Conversely, if your time-frame and the profile you have suggests equity as a major investment channel, then keeping money in even the best-chosen debt funds is opportunity lost.
As I’ve written earlier in these pages, investments are only about reaching your own financial goals, rather than about the investments themselves. Any investment plan should start with your own financial goals and that means not paying any attention to the actual investments. There is no investment that can be judged to be the right one without knowing who it is for and for why the investor needs it. There are great mutual funds and stocks which could be completely unsuitable for certain types of investors and for meeting certain types of financial goals. It’s a different matter that there are many investments that are always unsuitable for everyone. That’s a separate story.
The importance of thinking in these asset allocation layers is that making the right decision at a higher layer is far more important to your financial health. A wrong choice made at the beginning means that all the downstream choices are wrong by definition. However, the advertising hype and the salesmen’s pressure is all focussed at the final product-choice stage. If you listen to the noise, then you could end up choosing a product of the wrong type, whereas if you have already chosen the right type, then the chances of making a damaging decision is minimised.