After being clear with the aspects of Asset Allocation & Diversification, you need to start Defining Your Investment Objectives .
Factors to consider while Defining Your Investment Objectives
While creating a framework for yourself, you have to take into account these 3 things
1) Your investment attitude (conservative vs aggressive)
2) Your position in the lifecycle of investing (accumulation vs distribution phase)
3) Behaviour of stock markets over the long run
There are two categories of financial assets, Stocks and Bonds.
1) Your investment Attitude (Conservative vs Aggressive)
It will help you decide the stock/bond allocation. Each of us has a personality, based on your personality and risk tolerance you can decide where you belong to.
2) Your position in lifecycle of investing (Accumulation vs Distribution phase)
This factor again boils down to help you decide your stock/bond allocation. Based on your time horizon & income needs you can decide your investment objective.
For example, if you are accumulating assets for a short-term goal (1-2 years) you might want to be more conservative in your investment vs long term goal where you can be more aggressive.
3) Behaviour of stock markets in the long run
To understand this factor, you need to understand what derives the returns in stocks & bonds. For short term the markets may seem mysterious but in the long-term stock returns are driven by earnings and dividends, bonds return by investment coupons. Based on your view of how the behaviour will be in the long run, you can define your investment objective.
What comprise of returns in Stocks and Bonds
Stocks
Three elements comprise the returns on stocks
a) Initial dividend yield – Dividend is the distribution of profits by the company. Here we should not be confused if a company doesn’t pay dividend. If a company doesn’t pay dividend now, but is profitable, it’s ability to pay dividend in future rises. As an investor there is no difference to whether a company pays dividend or not, because if the company is not paying dividends, the company is sitting on extra cash which it can distribute but decided not to distribute. So, the share prices appreciate by the same amount.
b) Growth in dividends – It basically boils down to growth in profits which can be distributed to shareholders. Growth will also contribute to returns on stocks.
c) Change in price/dividend multiple – It tells how much price people are willing to pay to earn the amount of dividend the company is paying. If people are more willing to pay high prices, share prices will rise and return on stocks will increase.
Bonds
Total returns in bond comprises of three elements
a) Initial yield – This is the interest payments that one receives for investing in bond.
b) Reinvestment rate – The ability to invest the interest payments at the same or higher rates contribute to reinvestment rate returns in bonds.
c) Impact of rate change – It defines the impact of rate changes on the existing bonds. If the general interest rates in the economy decreases, the bonds which are sold earlier at a higher interest rate will become more valuable and vice versa. Hence the interest rate changes will also contribute to bond returns.