Understanding Asset Allocation and optimizing the same
How would your meal taste if you had only one food item on your plate? A little bland, perhaps. Even if it is the best item in the world, you may enjoy it for a few days, but in the long run, you cannot have a meal with only one ingredient - it is not complete.
Similarly, your investments are incomplete if you invest in a single asset class. With meals, you may have many options to put on your plate, but you only keep items on your plate that suit your tastes. Similarly, in investing, you need to have an asset in your portfolio based on risk profile, age, etc.
Where are we heading with this discussion? We are referring to asset allocation - an investment strategy that helps you find a balance between risk and reward for your investments. Today, we will discuss asset allocation in detail and how you can optimize it if you have not done so already.
What is asset allocation?
It is the process by which you invest money in different asset classes to create a balanced portfolio. The primary goal of asset allocation is to ensure that your portfolio performs well under various market conditions. If you check the past returns of different asset classes, it will be evident that no asset class performs well all the time. For example, equity gave excellent returns in 2020 and 2021, but in 2022 it underperformed. Gold investment delivered exceptional returns in 2020 but has remained flat for the last two years.
Below are two important points related to asset allocation:
- Risk-adjusted returns: You plan to get higher returns without increasing risks or maintaining the same return level while reducing overall portfolio risk.
- Diversification: You invest across asset classes that are not correlated in terms of performance.
Factors affecting the asset allocation decision
How do you choose assets in your portfolio, and in what percentage? The answer to this question will depend on the following factors:
- Your goals: Each investor has different financial goals, which will affect how they invest and the risks they can take.
- Risk Tolerance: In simple language, risk tolerance refers to how much you are willing and can lose on your investment in anticipation of higher returns. Investors with low-risk tolerance may want to have a minimum allocation to small and midcap stocks.
- Time horizon: The time horizon factor depends on how long an investor plans to stay invested. Different time horizons entail different risk tolerance, and time horizons will depend on your goals. In short, all parameters are interlinked - directly or indirectly.
How asset allocation works: an example
Let us understand asset allocation with an example. Assume your goal is to accumulate Rs 1 crore in the next 20 years, and you are comfortable investing Rs 10,000 per month. To achieve this, you need 12% returns over the next two decades. You can make a portfolio as follows:
- Large-cap stocks: 40%
- Mid-cap stocks: 20%
- Small-cap stocks: 10%
- Government bonds: 10%
- Debt funds: 10%
So if your portfolio size is Rs 1,00,000, you will have Rs 70,000 allocation in equity, Rs 20,000 in bonds, and Rs 10,000 in gold.
Strategies for asset allocation
In asset allocation, there is no hard-and-fast rule that investors need to follow. You can follow the strategy that you understand and can implement. Below are two simple asset allocation strategies to optimize your portfolio:
- Age-based asset allocation: Your investment decisions are based on your age. The rule of thumb is that your equity investment percentage allocation should be (100 - age). In this strategy, it is assumed that at a young age, you can take more risks.
- Constant-weight asset allocation: You do asset allocation based on different parameters (as discussed above). You review your portfolio after a fixed duration (half-yearly or yearly) and evaluate how the percentage has changed. In the above example, your percentage allocation in large-cap stocks was 40%. Assume that large-cap stocks performed exceptionally well during the year, and you now have 50% in large-cap, 15% in mid-cap, and 5% in small-cap. To rebalance, you will sell a part of your large-cap holding and reinvest it in small and midcap categories to bring your allocation back to your initial level.
The above two are easy-to-implement asset allocation strategies. There are a few more strategies, but they require some market expertise.
- Tactical asset allocation: It aims to maximize short-term investment strategies and hence adds more flexibility in coping with the market dynamics.
- Dynamic asset allocation: It enables you to adjust your investment proportion based on the highs and lows of the market and the gains and losses in the economy.
How to choose the right asset allocation?
Asset allocation is not a choice for investors but a necessity. Therefore, if you haven't incorporated this strategy into your investment journey, start NOW.
Each individual has unique goals in life. Therefore, an ideal asset allocation strategy must be customized to an individual's needs. Your asset mix should be based on your risk tolerance, which can change over time due to evolving goals, age, additional responsibilities/liabilities, etc.
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