A Beginner's Guide to Asset Allocation : Everything You Must Know

Asset Classes – Basic Understanding and Types

An asset class is a collection of securities that have similar financial traits like risk, liquidity, response to market volatility, tax treatment, returns, and ideal investment tenure. 

The concept of investing based on an asset class was popularized by mutual funds since they targeted investors with specific risk tolerances and needed to inform them about the range of securities they would potentially invest in.

For example, an equity mutual fund usually targets investors with medium-to-high risk tolerance and invests in stocks or equity-related instruments like preferred stocks, warrants, options, etc. Therefore, investors with similar risk tolerances would have an idea about the securities that the fund manager would invest in.

Here are some popular asset classes in India:

• Fixed-Income

These include government securities, corporate bonds, corporate debt securities, money market instruments, etc. All securities that offer a fixed rate of return until maturity are covered under this asset class.

• Equity

These include stocks and equity-related instruments. These securities offer returns based on their market performance which in turn is influenced by various social, economic, political, and other macroeconomic factors.

• Gold

This asset class acts as a portfolio diversifier. With its risk-reducing, return-enhancing characteristics, Gold will continue to be a stable form of money with the potential to store value in the midst of uncertainty for its holders for the foreseeable future. 

• Cash and Cash Equivalents

These include treasury bills, money market instruments, commercial papers, and any other securities that have maturity up to one year and are highly liquid.

Understanding Asset Allocation

Now that we understand asset classes, let’s look at how it stitches back into a strategic investment plan. Usually, investors have multiple financial goals. So, you can have a goal of buying a house in five years, you cannot ignore your child’s higher education costs due in 10 years or create a corpus for your retirement years.

Hence, you will have different investment horizons for each of these goals and varying risk tolerances too. While you might want to take added risks to generate wealth for buying the house, you might want to stick to low-risk investments for meeting the goal of your child’s higher education.

Hence, you need to choose asset classes based on your financial goals and the risks that you are willing to take. This means that you may have to allocate your money to different asset classes to achieve your various financial goals. 

Going back to our example of you planning to buy a house in five years and assuming that you are willing to take high risks with your investment, you can consider opting for equity as an asset class that offers higher potential returns but carries higher risks too.

On the other hand, for your child’s higher education, you can opt for a medium-risk alternative like a balance of equity and fixed-income investments to create a portfolio that has tolerable risks with reasonably high returns.

Asset allocation will depend upon the three parameters discussed initially – financial goals (returns expectations), risk tolerance, and investment horizon.

A Step-by-Step Guide to Asset Allocation

While I have explained the concept, here is a step-by-step guide to ensure that you allocate assets optimally:

Step 01: Assess your Risk Tolerance level

As explained above, your tolerance to investment risks can help you determine the asset classes that suit you. Risks mean the possibility of losing a part of your invested capital due to an underperforming investment.

Remember, that returns are directly proportional to risks. Hence, higher risks would mean higher potential returns and vice-versa. Each asset class has a risk level associated with it. By assessing your risk tolerance level, you can choose asset classes that are best suited to you.

Step 02: Identify your Investment Goals and Time Horizon

This will also help to determine the asset classes that are ideal for you. If you have short-term goals with a low tolerance to risks and are comfortable with medium-to-low returns, then Cash or Cash Equivalents can be considered. On the other hand, if you have a long-term horizon with a high tolerance to risks and desire high returns, then equity as an asset class becomes a better option.

Step 03: Choose a mix of asset classes to suit your requirements

Let’s say that you have a medium-to-high risk tolerance, an investment horizon of around 10 years, and the expectation of a double-digit return. While this sounds like the profile of an investor who should opt for Equity as an asset class, it does not mean that he should not consider other asset classes. Keeping your investment plan in mind, create a portfolio that has a mix of asset classes working together to minimize risks and maximize returns. Hence, you can look at Real Estate or even Fixed-Income securities and create a diversified portfolio. Diversification is all about investing in assets that have a low correlation to each other. Therefore, when one drops in value, the other is not impacted in any way.

Step 04: Always keep the broader financial picture in view

Most investors make some tax-saving investments, an insurance policy, and have bank fixed deposits before they start looking at investing for achieving other financial goals. Hence, while creating an investment plan and allocating assets keep all these investments in mind and don’t allow your investments to skew in any one direction. A balanced approach to investments is the best one.

Step 05: Review and Rebalance Regularly

Life is dynamic. Hence, financial goals and risk tolerance levels can change with time. Therefore, it is important to review your investments regularly and rebalance them based on any changes in preference that you might experience.

Regardless of your risk tolerance level, sticking to a single asset class increases the overall investment risk. Let’s say that you decide to invest in the Fixed-Income asset class that has low risk and low potential returns. Since you are trying to protect your capital, this makes sense.

However, last year we saw the RBI slashing interest rates to manage inflation and liquidity in the economy. This resulted in a drop in interest rates across securities offering fixed returns. Hence, if you were invested only in the Fixed Income asset class, then despite being a low-risk investment, your overall returns would have been impacted. However, if you would have invested in a mix of asset classes, then the risk might have increased a little but you could have earned better returns.

While on the topic of asset allocation, it is important to talk about portfolio diversification too.

Asset Allocation & Portfolio Diversification

Asset Allocation is about ensuring that the asset classes you invest in are in sync with your risk tolerance, investment horizon, and returns expectations. On the other hand, Portfolio Diversification is about minimizing the risks and maximizing returns of your investment portfolio without considering the investor’s profile.

Hence, portfolio diversification is a scientific process where the investor chooses asset classes that are not correlated with each other and tries to optimize returns while minimizing risks. On the other hand, Asset Allocation is an art where you understand your preferences and create a mix of asset classes best suited to you.

Summing Up

To summarize the entire concept in the simplest terms, before you start investing, understand (i) How much risk are you willing to take with your money?; (ii) The returns that you expect; and (iii) When you need your investments to provide returns? The answer to these three simple questions will reveal your profile and help you choose investments in a more informed manner. Asset Allocation is an important technique to help create an investment portfolio that resonates with your needs and expectations. We hope that this article helped you get a grip over the concept and inch towards becoming a better investor.

Happy Investing!

Disclaimer: This blog has been contributed by Quantum Mutual Fund AMC. The views expressed here are of the author and do not reflect those of Groww.