Asset allocation is a process of dividing one’s investments among different asset classes such as stocks, bonds, cash, real estate, etc. in such a manner that you can reach your desired financial goals by keeping in mind your age, risk profile, etc.
Different asset classes have different trajectories and needs. Cash or fixed deposits can be used to meet very short-term goals but cannot be used to meet long-term goals like a child’s education, retirement, etc. For those, you would require asset classes such as equities, different types of mutual funds, and others, which might be volatile in the short term but generate real returns (above inflation) in the long run to meet such inflation-heavy goals. Therefore, it’s important to spread your risk across different asset classes and get a decent risk-adjusted return. Putting many eggs in one basket is risky and the least recommended path.
The process of determining the right mix of assets for your portfolio is largely personal and the allocation can depend on the following: time horizon, risk tolerance, and age.
Strategies For Asset Allocation
- Based On Life Cycle: Also termed a target-date asset allocation strategy, it tries to maximise the return on investment of an investor based on factors such as the investor’s age, risk profile, and investment goals. The strategy varies from one investor to another.
- Based On Age: This asset allocation strategy takes the age of the investor and deducts it from 100 to determine the percentage of other asset classes to equity. So, for example, if an investor is 40 years old, the share to be parked in equity-related instruments is (100-40) = 60%; the balance should go to other asset classes.
- Constant Weight: Also known as strategic asset allocation strategy, this is a buy and hold approach. Under this strategy, if one asset class loses value, investors are recommended to buy more of it, and vice-versa. The idea is to stay as close as possible to the original asset mix percentages.
- Tactical Asset Allocation: This strategy aims to maximise short-term investment opportunities. It adds a market-timing component to the investor’s portfolio, allowing the investor to join in economic conditions that may be favorable for one asset class. This strategy can lead to quick changes in the percentage of allocation to various asset classes.
- Insured Asset Allocation: The base asset value is established; the portfolio value should not drop below this. If the portfolio value drops lower than this, the investor is recommended to avert the risk. This strategy is ideal for those who are risk-averse, for example, an investor looking for a minimum standard of living during his or her retirement with this corpus.
- Dynamic Asset Allocation: This is the most popular investment strategy. An investor constantly adjusts the mix of assets based on the highs and lows of the market and gains and losses in the economy. In this strategy, you purchase/sell the asset that shows continued growth/loss due to the economic situation.
Which Suits You?
Everybody’s financial situation, age, demographics, risk profile, etc. are different, therefore, every person will have a different asset allocation to take him to his financial goals. However, there is one universal truth: portfolios that have superior product selection and consistent asset allocation tend to outperform the market. Also, you have to dynamically revalue and realign your portfolio to get the best results.
It’s also important to understand the geopolitical and economic situation of the world and our country to define the construction of asset allocation. For example, if inflation is moving up and hence there is a chance of an interest rate hike, then it’s not prudent to buy a long-term debt now; it’s better to stay in a guaranteed debt product or a short-term debt fund.
Asset allocation is part of life cycle planning; the lesser the mistakes, the better it is.