Asset allocation and its importance in your portfolio

Have you ever wondered about the pie-chart that you come across in your account statement? Well, that is exactly the pictorial representation of your money which is allocated among different assets classes.

What is asset allocation?

Asset allocation is the financial strategy of allocating your investments to different types of assets. For example: Let us suppose you have ₹ 1 Lakh in your hand, and you would like to invest say 15% in equity, 25% in gold, 15% in fixed deposits, 30% in mutual funds and rest 15% probably towards recurring deposits. This division of your wealth into various financial avenues is known as asset allocation. However, the decision to allocate wealth varies from investor to investor as it depends on multiple factors like investor’s time horizon, risk appetite, liquidity and financial goals.

What is the connection between Diversification and Asset Allocation?

Diversification is a kind of approach that can be neatly understood by the timeless adage, “don’t put all your eggs in one basket.” Diversification involves spreading your money among various instruments in the hope that if one investment loses money, the other investments will more than make up for those losses.

Most investors use asset allocation to diversify their investments among asset categories. But other investors deliberately do not. For example, investing entirely in stock, in the case of a twenty years old investing for retirement, or investing entirely in cash equivalents like Fixed Deposits, in the case of a family saving for the down payment to buy a new house, might be reasonable asset allocation strategies under certain circumstances. But neither strategy attempts to reduce risk by holding different types of asset categories. So, choosing an asset allocation model won’t necessarily diversify your portfolio. Whether your portfolio is diversified will depend on how you spread the money in your portfolio among different types of investments.

Types of Asset allocation

In the literature of finance, asset allocation is broadly classified into two categories based on the nature of investing:

1. Tactical Asset Allocation: Tactical asset allocation allows little deviations from the already set allocation so that investors can take advantage of the lucrative investment opportunities. These opportunities arise when some unexpected event occurs for a short period of time. Investors who are following tactical asset allocation strategy are supposed to be active and alert. Once short-term profits are realized then they can rebalance their portfolio.

2. Dynamic Asset Allocation: This is suited to the financial environment which is frequently changing. Under dynamic asset allocation, investments are allocated amongst wide varieties of options. It allows investors to exit from a bad performing asset class and enter the one which is performing better. In simple words, the dynamic structure of asset allocation is the main advantage to beat off the market slumps. Experts believe that this is most appropriate for those who have limited funds but want steady returns at the end of period. Most importantly, dynamic asset allocation funds are preferred for recurring returns. Active investors’ i.e. who regularly check their portfolio can adopt this strategy and adjust their portfolios as per cycles of the market.

Factors to be considered before allocating your wealth:

There is no single tested formula for deciding an asset allocation strategy that works for everyone. It is different for every investor depending on time horizon, risks, liquidity etc.

Time horizon: Investors should first set a financial goal and then allocate assets to different classes so that they have clarity on how long they want to invest in. Investors who have a long-term investment horizon, can allocate some funds to comparatively risky assets. On the contrary, investors investing for shorter duration should opt for less risky assets in allocation.

Risk tolerance: Investor’s appetite or willingness to take risks and sustain the risks is another factor that should be considered before allocating resources. Investors who are aggressive in their investing can take high risk high return approach while conservative investors should be happy with low return investments by preserving capital.

Financial goals: Financial goals are different for different investors. Some investors want to invest for their children’s education. Others may want to plan for their children’ marriage. Some may want to improve their lifestyle. Others would like to buy a house. Some may be planning their after-retirement life. So financial goals are different. It is good to have a clarity on your purpose of asset allocation so that you can plan accordingly.

Liquidity: While allocating assets into multiple asset classes, it is advisable that you should put some money in highly liquid assets so that it can be of use in emergency situations.

Importance of assets allocation

Reduction in risks: The biggest advantage of asset allocation is that it reduces the risk associated with portfolio through diversifying the assets into multiple assets classes. Historically speaking, the returns on stocks, bonds and cash have never moved in same direction. There are certain market conditions where one asset class is under performing and the other is outperforming. Therefore, if your assets are well allocated then less returns in one asset class gets offset with more returns on other asset class. The overall risk is reduced, and investment portfolio becomes less volatile.

Optimize returns: Investors are to get assured returns through asset allocation as their wealth is divided into multiple categories of assets as per their preference of time and risks. Investing in a balanced fund under asset allocation strategy can fetch higher returns in longer run.

Taxation benefits: As your investment portfolio is widely spread, you can get taxation benefits and sometimes exemptions also wherever applicable. Taxation benefits will be more when assets in your portfolio have lesser correlation with each other.

Beating Volatility: An upward swing or a downward swing of an asset class cannot sustain for longer period. After every downward trend there is upward trend and vice versa. As your funds are allocated in different asset classes, you can beat off volatility because the falls will not be that drastic for you as it would have been if invested only in equity. A good asset allocation always minimizes the volatility.