People invest in a variety of instruments, including mutual funds, stocksgold, real estateamong many others, to achieve their financial goals. These instruments are typically divided into four broad categories: equityfixed income, cash or cash equivalents and alternative investments.
While equity includes market-linked instruments such as stocks and equity mutual funds, fixed income comprises debt instruments such as fixed deposits, debt funds, bonds, certificates of deposit and other government securities. Cash equivalents include Bank savings accountsmoney market funds, etc., and alternative investments include real estate, private equity, derivatives, arts, commodities, etc.When you allocate your investments across any of these categories in varying proportions based on your needs, you are allocating your assets, which is what asset allocation is all about.
FACTORS AFFECTING ASSET ALLOCATION
Asset allocation is different for every individual, depending on their financial objectives, the time horizon of their goals, as well as their age and risk tolerance.
Target value and time horizon: An investor usually chooses assets based on the amount he needs to achieve his goals and the time available to invest. Suppose you have a long-term investment horizon and want to accumulate a large capital for, say, your retirement. You can choose a high-risk, high-return asset like stocks and equity funds as your primary investment and invest a smaller amount in debt instruments. This is because you have time to weather any market fluctuations and still earn a high return from your equity asset. On the other hand, if your investment horizon is short, say, 2-3 years, you can choose a safer fixed-income option like a fixed deposit or debt funds as your primary asset because you need to preserve your capital.
Age and risk appetite: The age of the investor and his/her risk tolerance are also decisive factors, as at a young age one can afford to take risks and opt for market-linked assets, while at an older age safer instruments are required. Also, if one is risk-averse and not comfortable with market swings, assets will lean towards safer options such as gold, real estate and bonds.
WHY IS IT IMPORTANT?
Asset allocation helps manage and reduce portfolio risk while optimizing returns. This is because spreading investments across assets with varying risks means that in the event of market fluctuations, if one asset falls, another might rise, as not all assets move in the same direction. This provides stability to the portfolio.
ASSET ALLOCATION STRATEGIES
Strategic: Also called a “fixed” or “buy and hold” strategy, this involves sticking to a predetermined asset allocation over the term of your investment. So, if you decide to invest 75% in stocks and 25% in debt, you will retain this balance as long as you remain invested.
Tactical: Unlike the rigidity of strategic allocation, here the asset allocation is modified in the short term to take advantage of market opportunities. Therefore, if the market experiences swings, the proportion of assets can be changed to obtain higher returns. However, this requires experience in market movements and is not recommended for beginners.
Dynamic: In complete contrast to strategic allocation, this strategy allows you to continuously change your asset allocation based on changes in the market situation.
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