Asset allocation ensures that the portfolio remains diversified, and the risk is spread across asset classes, providing an inbuilt downside protection mechanism
Every investor has different goals, risk appetite and time horizon when it comes to their financial goals. Based on these factors, an investor can allocate investments across different asset classes such as debt, equity, gold, cash, real estate in the desired proportion as per one’s profile. This practice is called asset allocation. Asset allocation enables investors to tide over different market conditions comfortably by limiting the overall volatility in the portfolio.
Why Asset Allocation?
Markets in general are dynamic in nature. No two asset classes perform similarly at any given point in time. This is because not all the asset classes will react to a development in the same manner. Nobody can predict which asset class will outperform or underperform at any given point in time. Therefore, the optimal approach is to invest across asset classes. For example, when equity markets faced a sharp correction in 2020 owing to the news of the pandemic, gold rallied significantly.
Asset allocation ensures that the portfolio remains diversified, and the risk is spread across asset classes. An upward or a downward swing of any of the asset class will not have a sizeable impact on the portfolio. Hence, there is an inbuilt downside protection built into the portfolio. Over the course of one’s investing journey, there will be several developments along the way which can materially impact the market, but is an investor has followed asset allocation, then he/she will not have to concerned about the impact any of these developments can potentially have on the portfolio.
Challenges Faced
When a lay investor tries to invest across asset classes, he/she faces various challenges such as selection of the right asset classes in the right proportion, timing the investment, and taxation. Investors are inundated with information about various offerings spread across asset classes, and making a sound decision is no easy task. Furthermore, recognising the various ups and downs of a market cycle and investing accordingly is another challenge. Even if an investor were to succeed at allocating funds across asset classes, but while rebalancing the portfolio, such an investor is bound to attract short- or long-term capital gains tax on the trades made, which can act as a deterrent to rebalancing. As a result, the entire process of asset allocation looks like a tedious task.
The other major challenge an investor faces is behavioural in nature. Often investors tend to go overboard when it comes to investing in an up-trending asset class. Ideally, at such times, it is a wise move to book profits. But in the fear of losing out on further gains, investors tend to stay put. When a correction follows such a phase, most investors are caught off-guard and tend to move away from the market. On the other hand, when the market is facing a sharp correction, instead of investing, investors tend to wait on the sidelines due to fear of losing out on their investments. AS a result, they miss out on various good investment opportunities.
Solution
Given these challenges faced, mutual fund houses today offer asset allocation schemes which are dynamically managed. Here, the money is allocated across equity and debt asset classes. Equity here bring the growth element to the portfolio while debt brings in steady returns and downside protection. Basis the changing market environment, the allocation is managed dynamically. For example: When the equity market valuation is expensive, the allocation is largely made towards debt and vice versa.
So, the idea is to invest counter cyclically such that at all times, the portfolio is protected from sharp swings in any of the asset classes. As a result, such funds are built to take maximum advantage of the market volatility. Over the past one year when the market has been volatile, this is one category which could deliver a positive investment experience. It addresses all of the challenges faced by an investor mentioned earlier. Also, when the rebalancing is done an investor does not have to face tax incidence.
To conclude, adhering to asset allocation at all times is necessary step for a smooth investment experience. Opt for asset allocation schemes which will do the needful on your behalf.
Nasir Ahmed, MD, Jadepurple Investright Pvt Ltd
Disclaimer
The views are personal and are not part of the Outlook Money editorial Feature.