What Is Asset Allocation

Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance, and investment horizon. The three main asset classes - equities, fixed-income, and cash and equivalents - have different levels of risk and return, so each will behave differently over time.

Why Asset Allocation Is Important

By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Historically, the returns of the three major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you’ll reduce the risk that you’ll lose money and your portfolio’s overall investment returns will have a smoother ride. If one asset category’s investment return falls, you’ll be in a position to counteract your losses in that asset category with better investment returns in another asset category.

Investors may use different asset allocations for different objectives. Someone who is saving for a new car in the next year, for example, might invest her car savings fund in a very conservative mix of cash, certificates of deposit (CDs) and short-term bonds. Another individual saving for retirement that may be decades away typically invests the majority of his individual retirement account in stocks, since he has a lot of time to ride out the market's short-term fluctuations. Risk tolerance plays a key factor as well. Someone not comfortable investing in stocks may put her money in a more conservative allocation despite a long time horizon.

The Magic of Diversification

In addition, asset allocation is important because it has a major impact on whether you will meet your financial goal. If you don’t include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal. For example, if you are saving for a long-term goal, such as retirement or college, most financial experts agree that you will likely need to include at least some stock or stock mutual funds in your portfolio. On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it. A portfolio heavily weighted in stock or stock mutual funds, for instance, would be inappropriate for a short-term goal, such as saving for a family’s summer vacation.

The practice of spreading money among different investments to reduce risk is known as Diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.

Old Rule of Asset Allocation - The Thumb Rule:

One thumb rule that has been advised for years, is to reduce your age from 100 years and then, invest the resultant percentage of your money in stocks or equities. So if your age is 30 years, you must invest 70% (100 minus 30) of your money in the stock market. On the other hand, if your age is 70 years, you must keep just 30% of your money in stocks or related instruments.

This rule doesn’t take into account any risk profile or other factors. This is given that a person aged 30 years, may have a lot of near term-financial liabilities to meet – like down-payments for a house and/ or car, marriage, higher education, etc. Investing a large proportion of savings in stocks, which can lose a lot in the short term to medium term, can be devastating for such a person. Conversely, if a 25 years old doesn’t have any short-term goals or liability, then 75% (100-25) of Equity Allocation can actually be very less.

Similarly, a senior citizen of 70 years may have paid-off all his loans, and he might have children who are well-settled, and earns sufficient money as interest on his investments. For him, taking a high risk by way of investing a large part of money in stocks and related instruments is viable.

With today’s low interest rates, investors forgo a lot of return when holding too many bonds – so the recommended percentage of stocks has crept upward in portfolios. The professional investment world is trending closer to a rule of ‘120 – Your Age’ in stocks.

7 Rules of Right Asset Allocation:

1. Your Final Goal Strategy: Asset Allocation should be decided only based on your Financial Goals, Goals Timelines, Risk Profile and Expected Returns. 

2. Money needed within 1 year should be in cash: All money you need in the next one year – maybe for a loan repayment or for vacation expense – must be saved as cash. This cash could mean a short-term fixed deposit or a liquid funds.

3. Money you need in 3 years must also be kept safe: There may be some goals that you may want to meet over the next 2-3 years – like your car or for a family holiday. You must invest this money in safe, income-producing instruments like FD's, debt funds or recurring deposits.

4. Money you can keep aside for 5 years and more, must be in the stock market related instruments: Stocks have been great long-term performers over the past many years. In fact, if you were to go back into the history of Indian stock markets, over every rolling five-year periods starting 1979, stocks have outperformed bonds almost 65% of times. Further, for every 10-year rolling periods, stocks have outperformed fixed income instruments almost 80% of times. So the longer you have your money invested in stocks (or equity funds), the greater is the chance that you will make more than return, on fixed income instruments.

5. Not more than 30% allocation to Real Estate (excluding the home where you live in): Many of us tend to buy second home or land for investment which is not a right way of investment majorly because Real Estate is a complicated asset which blocks your big money in, and is difficult to sell this asset.

6. Not more than 5% allocation to Gold: Many of experts believe that Gold is a good hedge against equity. When the slowdown hits global markets, Gold prices do go up and vice versa. Even though it is a good hedge, still overall returns from Gold have been limited and it is dependent on other major factor i.e. Indian Currency fluctuation. This makes Gold Investments very prone to speculation.

7. No or negligible allocation to Crypto Currencies: There is a new asset which are gaining lot of press recently – Bitcoin and other crypto assets. These crypto assets are basically computer programs which can be traded on a platform called blockchain. Currently, there are no major application of this technology and all the crypto assets are gaining or losing market value just and just based on speculation. Even if their value becomes zero, no industry or no services will be impacted. Currently, investors should avoid these types of assets completely.

How to create & measure your new asset allocation?

Once you create your Financial Plan and identify the assets to invest, your allocation will change on a daily basis based on performance of these assets and your regular investments. These are the steps to work towards your new asset allocation –

1. First and foremost will be, to change the current assets based on your Final Goal strategy. For Example, if you have tagged a Fixed Deposit with your retirement goal (10 year +, 12% interest expectation) then, you should shift this Fixed Deposit amount to Direct Equity or Equity Mutual Funds.

2. Set a timeline of change – You may not want to switch the entire amount to new asset in one go and may like to do it in a certain period of time. It is important you fix this timeline and start the implementation accordingly. Please remember do not keep this too long (more than 1 year) as it will reduce their time in the market.

3. Start implementation of new investments based on the new financial plan immediately.

4. Measure the new asset allocation – Once you have switched your current assets based on your Goal strategy, started new investments as per the plan – You should measure the Asset Allocation and make sure you are meeting the 7 rules discussed above. You should review your asset allocation at least once a year and make changes if required depending on the 7 rules.

The next step is Portfolio Rebalancing to maintain the targeted asset allocation.
Read more here.

The most important key to successful investing can be summed up in just two words - Asset Allocation - Michael LeBoeuf

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