Asset Allocation - Definition and Importance

 

An asset refers to anything you own that can generate a positive economic impact and get converted into money. Say you purchase a home for INR 1 crore. After ten years, you sell the property for INR 4 crore. You can classify the house as an asset since it had a positive economic impact, a profit of INR 3 crore, and the value was converted into money. When you invest, you purchase assets that you can later convert into money to gain returns. Let’s learn more about assets and how to choose them.

What Is Asset Allocation?

Asset allocation is a key strategy in managing investments effectively. It refers to the strategic distribution of an individual's investments across different asset classes, such as stocks, bonds, real estate and money market instruments.

This approach allows investors to balance potential risks and returns based on their financial goals and risk tolerance. Optimal allocation of assets plays a significant role in achieving long-term financial security and provides diversification to protect against market volatility. 

What Is the Importance of Asset Allocation?

Optimal allocation of assets is crucial in achieving long-term financial goals while managing risk. It helps in maximising returns while minimising the impact of market volatility. By diversifying across various asset classes, investors can reduce the overall risk in their portfolios.

• Firstly, it helps to manage investment risk. By diversifying investments across various asset classes, your exposure to the potential downturn in any single investment is greatly reduced.
• Secondly, it aligns investments with specific financial goals and time horizons. By considering factors such as age, risk tolerance, and investment objectives, the allocation of assets ensures that investments are appropriately allocated towards growth, income, or preservation.
• Lastly, it helps in maintaining a disciplined approach to investing, preventing impulsive and emotional decisions based on short-term market fluctuations.

How Does Asset Allocation Work?

Asset allocation works by carefully distributing investments among different asset classes. This distribution is based on an individual's risk profile, financial goals, and time horizon. A diversified portfolio typically includes a mix of stocks, bonds, ULIPs, Savings or Retirement Plans, and cash equivalents etc.

The goal is to balance the potential for growth and income while considering the risk tolerance of the investor. Allocation of assets also involves periodically rebalancing the portfolio to maintain the desired allocation as the market fluctuates.

What Is Age-Based Asset Allocation?

Age-based asset allocation refers to adjusting the investment mix based on an individual's age and the time remaining until retirement. It recognises that risk tolerance and financial goals tend to change as investors age. Younger individuals have the advantage of a longer time horizon, allowing them to have a higher allocation to equities for potential growth.

As retirement approaches, a portfolio may shift towards a more conservative allocation to preserve capital and generate income. A general guideline suggests, subtracting the investor’s age from 100 and the result so fetched must be his/her investment in stocks. With this approach, a 30-year-old would invest 70% of his money in stocks and 30% in debt funds or bonds.

How to Increase Asset? 

While selecting assets, you must understand how each one aligns with your financial goals. Certain assets, such as equities, could offer higher returns in the short-term, depending on market conditions. Debt funds, on the other hand, offer lower returns but less risk. The asset allocation process should be highly personalised based on your goals and risk appetite. Let’s look at how different kinds of investors may weigh assets while investing:

• Conservative or Risk-Averse Investors

  Assume you are investing for your retirement. You do not have a financial safety net to fall back on, so you want to minimise your exposure to risk. You can choose investment vehicles that invest in low-risk market instruments like government bonds and debt funds. Most guaranteed income plans in the market invest only 5% in potentially high-risk tools like equity funds and the balance 95% in low-risk debt funds.

• Wealth Creation or Very Aggressive Investors

  Younger investors who want to build long-term wealth can often afford more risks than others. They have minimal financial obligations and want to focus on creating a significant nest egg for the future. Very aggressive investors can increase their exposure to high-risk investments like equities. Over time, they can change their asset allocation to make it more conservative. These investors can start with equity exposure up to 60% and slowly reduce it down to 10% or 5%.

The above examples provide two extremes of how you can work out your asset allocation. Most investors use moderately conservative, moderate or aggressive approaches to their investments. Let’s look at how these investors allocate their assets:

Investments Allowing Flexible Asset Allocation

As an investor, you should always decide on the allocation that makes you feel comfortable. However, you may not always have the expertise to select the ideal allocation or make changes as required over time. Instead, you can opt for an investment that allows you to decide on the allocation and make necessary changes. Let’s look at some examples of such investments:

• National Pension Scheme (NPS)

  Several Indians invest in the NPS to help them create a corpus for retirement. Investors can choose to open only a Tier I account for retirement. Those who have a Tier I account may choose to get a Tier II account for non-pension investments as well, but there are limits on the amounts.

  Irrespective of the type of NPS account you have, you have the liberty to choose the assets in your portfolio. The NPS puts a cap on your exposure to equity funds, but you can choose the allocation for corporate debt, alternative assets and debt funds. You can opt for the auto allocation option, which automatically chooses allocations based on your age. Alternatively, you can opt for the active choice and pick your allocation based on personal financial goals.

• Unit-Linked Insurance Plans (ULIPs)

  ULIPs provide investors with life cover while helping them build a corpus for the future. When you purchase a ULIP, a portion of your investment amount gets used as a life insurance premium. The rest goes into debt and equity funds based on your risk appetite. Some investors choose to invest only in debt or equity funds, while most choose hybrid fund options that invest in both. You can set your asset allocation when you start investing. Over the course of your investment, you have the ability to make changes to your allocation. When the market performs well, you can redirect more of your investment to equity funds. Conversely, if there’s a downturn, you can put more money into debt funds.

  Many young individuals worry about making the wrong kind of investment. By understanding your risk appetite and financial goals, you can pick an asset allocation that works best for you. You can always ask for help or purchase plans like ULIPs where a professional manages the money on your behalf.

What Are the Factors Affecting Asset Allocation?

Factors such as risk tolerance, time horizon, financial goals, and market conditions can influence fund allocation decisions. It is important to regularly review and adjust the allocation of funds based on changing circumstances to ensure your portfolio remains aligned with your investment objectives.

• Risk Tolerance: Consideration of an individual's ability to endure fluctuations in investment values.
• Investment Goals: Identification of short-term and long-term financial objectives.
• Time Horizon: Evaluation of the length of time an individual has to achieve their investment goals.
• Age: Recognition of how an individual's investment strategy may evolve as they get closer to retirement.
• Market Conditions: Assessment of prevailing economic conditions and market trends.

What Is an Asset Allocation Fund?

An asset allocation fund is a type of mutual fund that automatically diversifies investments across various asset classes. These funds are managed by investment professionals, who aim to maintain a specific allocation strategy based on predetermined risk and return objectives. These funds are designed to provide broad exposure to different asset classes without requiring individual investors to manually adjust their allocations.

What Is a Good Asset Allocation?

A good asset allocation is one that aligns with an individual's financial goals, risk tolerance, and time horizon. It should be diversified across different asset classes to minimise risk and maximise returns. Generally, a good fund allocation involves investing in 60% stock and 40% bonds. However, the ideal allocation can be different for investors with different risk tolerances and ages.

Conclusion

Asset allocation holds paramount importance in achieving financial goals by effectively managing investment risk and aligning portfolios with individual objectives. Investors can reduce risks and increase potential returns by spreading their investments across various asset classes. Factors such as risk tolerance, investment goals, time horizon, age, and market conditions impact fund allocation decisions.

FAQs on Asset Allocation

1. What do you mean by asset allocation?

It is the process of distributing investments among various asset classes, such as stocks, bonds, and cash, to achieve an optimal balance between risk and reward.

2. What are the types of asset allocation?

Some of the types of asset allocation are strategic asset allocation, tactical asset allocation, dynamic asset allocation, and constant-weighting asset allocation. Each type involves different approaches to managing investments based on market conditions and individual preferences.

3. Why do you need asset allocation?

Allocation of assets is essential for managing risk and optimising returns in investment portfolios. It helps in diversifying investments across various asset classes to minimise the impact of market volatility and achieve long-term financial goals.

4. What are the advantages of asset allocation?

The advantages of the allocation of assets include risk diversification, the potential for higher returns, and protection against market downturns. By spreading investments across different asset classes, investors can achieve a more balanced and resilient portfolio.

5. What is a good asset allocation?

A good allocation of assets is one that is customised based on an individual's risk tolerance, financial goals, and time horizon. It should be well diversified across various asset classes to minimise risk and maximise returns. Regular monitoring and adjustments are essential for maintaining an optimal allocation of assets.

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ARN - ED/03/24/10390