Asset allocation is a technique that helps you manage risk and diversify your portfolio in the most optimum way possible. With so much to choose from, investing can become quite overwhelming leading to a state of eternal confusion and indecisiveness.
When you step into the world of investments, you are bombarded with options like mutual funds. bonds and stocks and however seasoned you maybe, confusion is bound to happen.
Stock picking is an essential part of successful investments, if you have picked up the right stocks then you have laid a strong foundation for your financial future. But easier said than done, stock picking can be highly tedious and analytical in nature.
Before jumping onto stock picking, you must have clarity regarding what kind of mix would you prefer and is most suitable to your investment portfolio.
A mix of stocks, mutual funds, bonds, real estate, and gold is generally preferred to be the ideal mix for an optimally diversified portfolio yet there are conditions to it.
In this article
Asset allocation: what is it?
Asset allocation by definition refers to a technique that helps spread the risk by diversifying your investment portfolio across different types of asset classes. With each asset comes different levels of risk and return hence balancing out the overall risk of an investment portfolio.
How does asset allocation work?
Asset allocation works on the simple fund of investing in different types of assets and their derivatives which helps spread the inherent risk across the portfolio.
For example, let us say you have invested in a mix of equities, debt funds, fixed deposits, real estate, and gold. Now in the current scenario, equities and real estate are in their low market cycles while debt funds are giving out moderate returns. Gold is the star performer in this slow-down phase as the stock market and gold market share an inversely proportional relationship.
Now since you are invested in assets that are both high risk and low risk, the severe impact of high-risk assets is balanced out by the subtle effect of low-risk assets, moreover since is returning high, it is an added advantage.
That way you have your assets allocated across different asset classes and are headed towards an optimal portfolio diversification.
If you talk to a financial planner or for that matter any number of financial planners, you will find one suggestion common that asset allocation is even more important and crucial than stock picking.
However fine selection you may do of your stocks and bonds and funds, if you place them wrongly under wrong investment horizons under the wrong risk and return profiles, you are bound to incur losses.
Asset allocation is custom-fit for every investor, there is no size that fits all when it comes to money management. Also, there is no set formula for to define right asset allocation but here are few insights that may help you in doing so;
Comparing risk and return profiles
While most investors chase return in their search for the right fund, it is one of the biggest mistakes you can commit as an investor. In the fight for returns, we ignore associated risk while bites in the back later.
Yes, everyone wants a portfolio that is promising and gives high returns but it would be foolish to ignore an equally important aspect called risk profile. Considering and calculating the risk appropriately differentiates successful and greedy investors.
Also, while you invest in direct stocks, you must prepare yourself to go through and overcome the bearish market during one of the cycles.
Define your goals – both long and short-term
Having a goal is a must while you step ahead to invest your money. Of the few first things, you must know towards what are you investing in? Ask yourself the question “Why am I investing?” and keep asking till the time you get an answer which may be a little vague but not off the track.
Having goals brings a lot of definition to investing and highly regulates your asset allocation. You can then be in a better position to define if you want to invest large-cap, small-cap or mid-cap funds or what combination would be the best or which fund to dedicate to what horizon short-term or long-term.
This can be better explained with an example, let us say you are a 28-year-old having 2-3 board life goals like building a retirement corpus, buying home and funding your marriage.
Now funding your marriage would be a short-term goal, buying a home would be a mid-term goal and building your retirement corpus would be a long-term goal.
For all your long-term goals, you can try investing in the stock market without worrying about temporary market fluctuations and corrections. For your mid-term and short-term goals, you must take into account your risk appetite and risk tolerance and invest accordingly into avenues that are best suited.
Time is your best friend and worst enemy. Best friend if you encash it on time, save and invest early and build a corpus of your dreams. Time is your worst enemy if you let it loose, procrastinate investing and let go off the opportunities you get to build your dream life and corpus.
The earlier you invest, the more rewarding it would be as the power of compounding would work for you in all those years of being invested. There is another theory which prevails in the financial market called time value of money which means evaluating your time in term of money. So the sooner you start, the more time you invest, the higher the rewards are.
Now that you have made the blueprint, have evaluated risk and returns, set your assets according to your life goals and have calculated the time value, what is stopping you? Do not let investor inertia stop you from taking the right step. This is the time you implement your plan on asset allocation an see how it works out for you. You need to categorize your stocks and bonds based on their horizon and market cap. Once you get the hang of it, get going!
How to decide the right mix?
As mentioned above, there is no one-point solution to asset allocation. It is tailor-made for every investor depending on their risk profile, tolerance, investment horizon, return expectations and most important goals and objectives.
Once you get some clarity over these things, you can allocate your assets accordingly which is also influenced by how much money can you push into the market. If you are planning to invest over a long horizon, investing in high-risk, high-return instruments would be the best option.
On the other hand, if you are investing for a short investment horizon then low-risk, low-return instruments would be more suitable.
Generally, asset allocation is dealt with as a subject to investor’s behavior. There are separate recommendations for an aggressive investor and a different lot for a conservative investor. The former focuses on capital appreciation while the latter on capital preservation.
The middle way
With the mixed approach investors adopt these days, the most sought-after portfolio is the moderate portfolio which is a mix of both aggressive and conservative behaviors. There are two variants to it:
Moderately aggressive and Moderately conservative.
It focuses majorly on capital preservation with some focus on capital appreciation where the investor is willing to stretch their risk appetite a bit.
It focuses majorly on capital appreciation with some focus on capital preservation where the investor is willing to put some money in risk-free investments.
Asset allocation is basic to investing and profit-making. Every investor needs to put in an effort that ensures they are invested in the right mix of funds which helps them reach their ultimate investment objective. Picking up the right asset allocation strategy will define the course of your invested life. Be vigilant and thoughtful before you pick one.
Disclaimer: The views expressed in this post are that of the author and not those of Groww