Want to know the importance of asset allocation? Read to find a complete guide on asset allocation, asset classes, its importance, features, benefits and how it works.
Asset classes don’t move in the same direction
During March – April 2020, when the Covid-19 scare gripped the stock markets, they tanked by almost 50%. During the same time, gold which is considered a safe haven during uncertainty gave one of the best returns in the last many years. The fixed income held steady for some time, and then the central banks cut interest rates. Hence, you need to have proper asset allocation by investing in different asset classes so that if one asset class doesn’t do well, the outperformance of other asset classes makes up for it. This article will discuss all about asset allocation – Allocation of funds, overview, and examples.
What is asset allocation?
Asset allocation is an investment strategy that helps an investor build a well-diversified investment portfolio to balance risk and returns. Asset allocation requires investors to invest their money in different asset classes such as equity, fixed income, gold, real estate, etc.
To start with, every asset class is given a specific percentage of the overall investment portfolio. However, going ahead, the asset allocation strategy may differ. Some asset allocation strategies require an investor to rebalance the allocations to the chosen asset classes to revert to the base allocation they started with. Some asset allocation strategies require an investor to increase allocation to a certain asset class (for example, debt) and decrease allocation to a certain asset class (for example, equity) as the age of the investor increases.
Importance of asset allocation
If you look at the history of different asset classes and compare them, you will find very little correlation between them, and they move in opposite directions most of the time. This is where the importance of asset allocation comes in. It requires an investor to invest in different asset classes. So, suppose one asset class is performing poorly. In that case, the outperformance of other asset classes in the investment portfolio can make up for it, and the overall portfolio can still give good returns.
Also, no investor can be sure which asset class will outperform in the future. Hence, an investor needs to have proper asset allocation to different asset classes so that whichever asset class outperforms in the future, the investor’s overall investment portfolio will do well.
Factors that affect asset allocation
Some of the factors that affect asset allocation include:
Investor’s risk profile
An investor’s risk profile affects asset allocation a lot. If an investor has an aggressive risk profile, they will be open to taking higher risks by allocating a bigger portion of their investment portfolio to equity mutual funds. If an investor has a moderate risk profile, they will prefer to have an equal allocation to equity and debt. If an investor has a conservative risk profile, they will prefer to have a higher debt allocation and a low equity allocation.
Investor’s age
As an investor’s age increases, their risk-taking ability decreases. Also, with life events, an investor’s risk-taking ability will change. For example, when an unmarried individual doesn’t have any loans and has just started working, their risk-taking ability will be high. They will be open to having a higher equity allocation at this stage.
As the investor’s age increases further, and they are married and have taken out a home loan, the risk-taking ability will decrease. Accordingly, their asset allocation will have to be modified.
As the investor’s age increases further, and they have a kid, and also have to take care of financially dependent parents, the risk taking ability will decrease further and accordingly their asset allocation will have to be modified.
Investment time horizon
The investment time horizon directly influences the asset allocation. For example, an investor has a short-term goal of accumulating ₹5 lakhs to purchase a car in three years. Since the investment time horizon is only three years, the investor will have to allocate most money to debt and very little to equity.
Similarly, an investor has a long investment time horizon of, for example, 15 years for building a retirement fund. In this case, as there is a lot of time for achieving the financial goal, the investor can allocate a larger portion of the investment portfolio to equities.
Different asset classes: Allocation of funds
An investor can allocate money from their investment portfolio to various asset classes such as:
- Domestic equity: Equity as an asset class is risky, but it also has the potential to give inflation-beating high returns. In the long run, equity can create wealth for investors.
- Debt: Debt lends stability to an investment portfolio. Debt carries low risk and can give low to moderate returns. When equity markets are falling sharply, debt cushions the impact on the investment portfolio.
- Gold: Gold is considered a safe haven during uncertain times such as a pandemic, war, recession, political uncertainty, trade wars, etc. Gold is also considered a hedge against inflation. So, when there is high inflation or uncertainty, gold tends to do well.
- International equity: It provides you with a hedge against country-specific risk. Also, investing in the US stock markets gives you an opportunity to invest in FAANG stocks and other global companies, which is not possible in Indian stock markets.
How does the asset allocation strategy work?
There are various asset allocation strategies. But, in this article, we will discuss only the strategic asset allocation.
Strategic asset allocation: It involves allocating a specific portion of the investment portfolio to each asset class. The portfolio is reviewed from time to time, and the allocations to each asset class are reverted to the base allocation.
For example, Ashish started with the following asset allocation: equity (70%), debt (20%), and gold (10%). Equity and gold did well during the year, and debt was steady. By the end of the year, the asset allocation changed to equity (75% – up by 5%), debt (10% – down by 10%), and gold (15% – up by 5%). During the review, Ashish will have to sell some equity and gold and invest that money in gold such that the asset allocation reverts to the base allocation of equity (70%), debt (20%), and gold (10%)
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