Insight on Asset Allocation

Most important investment activity you can possibly do!!

While investing in different asset avenues, people generally listen to advice of relatives and friends, read newspaper articles, financial blogs & so on. This is because every investor normally comes across two questions:

1. What are the investment avenues available?

2. How much should I invest in each avenue?

An advice or suggestion which acts good for one investor may not be good for another. This is because every investors faces different factors such as risk tolerance (i.e. how much volatility I can handle?), time horizon (how long my asset should last?) and financial situation (i.e. lifestyle and current assets).

The answer to above situation is “asset allocation” constructed and executed in a right manner. Asset allocation is distribution of money across different investment avenues considering your risk tolerance, time horizon and financial situations.

Today, there are various investment options available such as equity, debt, real estate, precious metals, bond, cash etc.  But, how much an individual should invest in each of these assets differs from investor to investor. Every asset plays an important role in your portfolio. Hence, it is equally important to allocate or distribute your money across various assets in a right manner.  For instance, every time any investment asset moves higher, investors tend to invest a large portion in such asset, ignoring the other assets. Imagine if this asset decline to a great level in near future, the investor would lose a big amount of money. Hence to avoid such situations, no single asset should occupy a larger than necessary share of any investment plan. Having different assets in a portfolio is beneficial because different assets react differently to same factors. A decline in one asset can be partially offset with the presence of other assets, which are not witnessing the same decline. Hence, correct asset allocation protects the downside of an investor.

Assets are also diversified as per the risk tolerance level of an individual. For instance, an individual, age 27yrs, unmarried and has no dependents must form equity as a part of his portfolio, as he is young with more appetite for risk. In the long run equity can add a considerable value to his portfolio.  Similarly, a person with advanced age and having dependents has lower risk appetite and time horizon. Hence, he should include a lot of fixed income assets to his portfolio.

Asset allocation is not only to diversify across different assets, but one can also diversify within each asset class. For e.g. while investing in equity, one can further divide the funds in large-cap stocks which are less risky than small-cap stocks. One can have such endless combinations, but the main idea remains the same i.e. diversification by balancing the risk and return within the portfolio.

Asset allocation also helps in minimizing the tax to be paid, as different types of investments have different tax treatments. Assets can be allocated in such a manner that the after tax returns are maximized.

Now, that you have understood the importance of asset allocation, start categorizing your assets and liabilities. Create a table to assess where most of your assets are held. This will help you to understand whether your money is invested in a single asset class or evenly distributed. Once you understand your asset allocation you can now decide how to maximize returns and minimize risks by changing percentage of investment in each asset. You can make a financial plan too & get advice on your asset allocation.

Once you have formed your initial asset allocation strategy make sure to rebalance it from time to time to maintain the original asset allocation and to balance it as per market conditions.

Overall, a well constructed and executed asset allocation strategy provides consistent returns, reduces the volatility of the portfolio and pays off better returns over a long period of time, which naturally every investor desires.

Hence, follow the asset allocation strategy that is right for your investment objectives, your risk tolerance level and your investment time horizon. Happy Investing!