Asset Allocation is defined as a process to distribute your investment across a range of asset classes in order to maximise the portfolio returns through effective risk mitigation and minimising volatility. There are primarily three asset classes: equity, debt and cash equivalents. The financial instruments corresponding to each asset class may vary, for example equity as an asset class may contain shares and equity mutual funds.
Understanding what Asset Allocation means is no big thing, but learning how to do it judiciously requires years of practice and a good amount of financial knowledge. The main idea is to allocate the investment money in such a way that the market forces don’t affect the entire portfolio all at once.
Why is Asset Allocation Important?
The whole idea behind asset allocation is diversification of portfolio. Different investment instruments in the market react differently to the market movements. One asset class may have massive gains, while the other may repost huge losses. If you’re wholly invested in one asset class, say equity securities, there’s a high possibility that you may lose your entire investment in one go, if the equity market enters a steep correction. To prevent this from happening, it is required to distribute your investments into various asset classes, so as to maximise portfolio returns and reduce the effect of market volatility on the portfolio returns. This is done through asset allocation.
In the long run, one greatly benefits from asset allocation, as over the years the diversified portfolio witnesses greater returns and lesser losses, as opposed to a portfolio which is concentrated into one type of asset.
Factors Affecting Asset Allocation
- Investment Goals
Each individual has certain aspirations that are fulfilled through creation of goals and working towards achieving them. Asset allocation largely depends on your financial goals, and how you plan to achieve them. The kind of financial goal has a direct impact on the risk tolerance and investment strategy of the individual.
For instance, if you’re saving for your retirement and have an ample amount of time, your investment portfolio will be skewed towards equities. If you wish to save for short-term goals such as buying a car, then the portfolio will be largely inclined towards debt securities.
- Risk Appetite
Risk appetite of an investor refers to how much s/he is willing to forgo the initial investment amount, in order to earn high returns in the future. This attribute of an investor has a direct impact on asset allocation. For instance, an investor with high risk tolerance would allocate the majority of his/her assets to high-risk investment instruments such as small cap equities. On the other hand, a conservative risk-averse inverter is likely to invest predominantly in safer avenues such as fixed-deposits or highly rated debt securities.
- Investment Horizon
Investment horizon refers to the duration for which the investor wishes to invest. This is dependent on numerous factors such as age of the investor, financial position and goals. An investor in his late 20s would have a much longer investment horizon when compared to an investor who’s in his 40s.Also, the kind of financial goals also determines the investment horizon of the investor. The investment horizon for saving for retirement, wedding and higher education expenses of children is longer as opposed to the investment horizon for short term expenses such as buying a car, etc.
How Can You Use Asset Allocation to Augment Return on Investment?
Have you ever thought that the reason behind not earning sufficient returns or losing the invested capital may be the investment strategy, and not the market forces. To earn significant returns that are not affected by cyclical downturns, one should carefully formulate the investment portfolio by appropriate allocation to all asset classes. There are typically three steps to create wealth and enhance your investment returns, through proficient asset allocation.
- Secure your portfolio:
Firstly, investors should allocate a certain portion of investment to safer investment avenues such as gold, provident fund, fixed deposits. These would grow marginally over a period of time, but will give a much needed security to the overall investment portfolio. In case the stock market crashes, this part of the portfolio will still be growing, and prevent capital erosion.
- Grow Your Wealth:
After allocation of a specific portion of investment to risk-free assets, investors should allocate a significant portion to avenues that’ll augment the portfolio returns and aid in wealth creation. This component of the portfolio will be growing exponentially over the years and will help fulfill long term financial goals. It can include shares, equity mutual funds, long-term bonds, etc. Investment should be done after through market analysis, and should be monitored from time to time.
- Risky Bet:
The last component of this strategy involves investing in risky endeavours. This may include volatile assets such as small cap equities, or investment in commodities (except gold). Only a small portion of portfolio should be allocated to these, as they carry high risk and the possibility of capital loss is significantly high. This component of the portfolio will give a boost to the overall returns if the market sentiment remains in favour of the investor.
It should be kept in mind that as soon as the percentage allocation of any of the asset classes rise, investors should quickly shuffle the fund to restore the original asset allocation percentage. For example, if the equity allocation was 40%, and it rises to 50% over a period of time, then the investor should transfer the extra capital to other asset classes, like debt. This strategy reduces the overall portfolio risk, and prevents capital erosion during unforeseen market movement.
Conclusion
Each individual has a different set of aspirations and risk appetite, which should be known before one starts investing, these can change in the lifetime as well. It should be noted that, there is no universal asset allocation strategy which is perfect for all the investors. Every investor needs to analyse his/her goals, risk tolerance and investment horizon to formulate a personal asset allocation strategy.
