Asset allocation is a very important part of creating and balancing your investment portfolio. This term is widely used by the financial expert. It plays an important role in maximizing the portfolio’s overall return. The most famous phrase ‘Never put all your eggs in one basket’ is used to simplify the term Asset allocation.
What is Asset Allocation?
Asset allocation is the process of deciding how to divide your investment across several asset categories. Stocks, bonds, Mutual funds, other debt instruments, and cash or cash alternatives are the most common components of an asset allocation strategy. Asset allocation means diversifying your portfolio. The construction of the portfolio involves allocating money to various asset classes. This process is called Asset Allocation.
In simple words invest your money in different types of an investment product to minimize your risk and maximize the returns. The asset class can be cash, equity, debt, real estate and gold. Asset Allocation depends upon your age, risk-taking ability and time horizon for the particular goal. Asset Allocation also provides for a direction to the future income and cash flows of the investor in terms of where he should invest to achieve his/her financial goal.
It is very difficult to determine which particular asset class would be the best performing one in a given year. Investing in only one class of asset in the expectation that it would outperform all the other investment categories could prove to be risky. If a portfolio is diversified, then irrespective of which asset class is out performing the investor will have some exposure to each one of it. The better performing asset classes in the portfolio will help protect the returns of the portfolio from the poor returns in other asset classes. Asset Allocation reduces overall risk in terms of the variability of returns for a given level of expected return. Therefore, having a mixture of asset classes is more likely to meet the investor’s expectations in terms of amount of risk and possible returns.
Asset allocation linked to Financial goal
When a need can be expressed in terms of the sum of money required and the time frame in which it would be needed, we call it a financial goal. Asset allocation linked to financial goals is the most appropriate form of asset allocation strategy. The investment horizon is a function of the investor’s financial goals, depending on when the money would be required to fund some of the life’s special events.
While implementing as asset allocation linked to your financial goals, you should consider following steps
Assessment of your risk profile based on ability and willingness to take risk.
Assessment of the needs. How much money will be required and when? You also need to assess the available resources and matches the same with the need.
Selection of the asset classes based on risk taking ability and time frame.
Lets understand this better through the live case
One of my client, Rahul, 35 yrs old, is planning for his retirement. Looking at his age and earning capacity I suggest him following asset allocation. This particular asset allocation is suggested for this goal only and that to for this financial year. As years pass his asset allocation will be going to change accordingly.
- Retirement planning: 70% Equity 30% Debt
Investor should build their Equity portfolio based on Core and satellite approach. In this pattern, Rahul’s 70% proportion of money is invested in Large and Multi cap fund. The large-cap can generate 10 to 12% returns for SIP investments. These funds provide stability and minimize the downside risk of the market. The remaining 30% portion is invested in good quality in Mid and Small Cap as satellite portfolio which has the potential to generate 15 to 18% returns.
So for Equity Rahul can invest in
- Good quality large and Multi cap fund,
- One passive Index Fund and
- One Mid and Small cap fund.
For Debt part Rahul can rely on PPF and EPF options. PPF and EPF are the best debt instruments for Retirement planning.
Contribute 1.5 L every year in PPF. Also use long short debt fund as one of the debt instrument. So for Debt Rahul can invest in
- PPF
- EPF
- Long term debt fund
Apart from these two asset classes one can invest in Gold, Real estate, Cash equivalents, bonds etc according to his/her risk profile and time horizon of the financial goal.
Asset allocation is a very important part of creating and balancing your investment portfolio. It plays an important role in maximizing the portfolio’s overall return. One has to keep an eye of this asset allocation strategy and review it once in a year.
Always remember : Never put all your eggs in one basket