What is Asset Allocation & it’s Importance?

What is asset allocation?

Asset allocation is an investment strategy that aims to balance risk and reward by dividing an investment portfolio among different types of asset classes such as equity, fixed income, cash and cash equivalents, real estate, etc. The theory is that asset allocation helps the investor to lessen the impact of risk their portfolio is exposed to as each asset class has a different correlation to one another.

Importance of asset allocation

Different asset class move in different directions. All types of asset classes hardly perform in tandem. One might assume that it is best to invest in mutual funds that is performing really well at a particular time with an aim to time the market. However, it is quite challenging for any individual to predict in which direction any asset class would move at any given point of time. For instance, when equities may be up, gold investment might go down and vice versa. So, it makes sense to allocate investments in a mix of asset classes. This is done so that if one set of asset classes or funds underperforms, the other asset classes will balance the underperformance. Investing one’s portfolio in just one asset class or mutual fund scheme can be extremely risky. However, if an investor’s wealth is spread across asset classes, they tend to make better returns. 

Factors that can affect asset allocation

The process of determining the right mix of assets for your portfolio is a very personal one. When making investment decisions, an investor’s asset allocation decision is influenced by various factors such as personal financial goals and objectives, risk appetite, and investment horizon. Let’s understand these factors.

1. Time of horizon
   Time horizon is the number of months or years an investor is expecting to invest to achieve a particular goal. Different investment horizons entail different risk tolerance. For instance, a long-term investment horizon might prompt an investor to invest in a higher risk portfolio as the slow economic cycles and high volatilities in the market tend to ride out with time.
2. Risk tolerance
   Risk tolerance refers to an investor’s willingness and ability to lose some or all of their original investment in anticipation of greater potential returns. Aggressive investors, or investors with high risk profile are likely to risk most of their investments to get better returns. On the other hand, conservative investors, or risk-averse investors are likely to invest in securities that preserve their original investments.
3. Risk vs returns
   When it comes to investing, risk and returns are inseparably intertwined. The phrase “no pain, no gain” closely sums up the relationship between risk and reward. All investments hold some level of risk. The reward for undertaking risk results in higher potential for better returns.

What are the different asset classes/categories?

Historically, there were 3 primary asset classes. However, most financial experts agree that there are 4 broad categories of asset classes. These are:

1. Fixed income: It is one of the most popular and oldest forms ofinvestment options. It includes corporate debt securities, money market instruments, corporate and government bonds, etc. Such instruments invest in debt securities that pay investors fixed interest payments until maturity of the scheme.
2. Equity Equity or stock are shares of ownership owned by publicly traded companies. Over the last decade, equity has gained immense popularity.&nbspEquity funds are further sub-categorised into small-cap funds, mid-cap funds, large-cap funds, large and mid-cap funds, multi-cap funds, contra funds dividend, value funds, yield funds, sectoral funds, focused funds, and Equity-linked Savings Schemes (ELSS).
3. Cash and cash equivalents: Also known as money-market instruments, these asset classes are securities that are best suited for short-term investment goals. The primary advantage of these instruments is their liquidity. Cash equivalents, such as treasury bills, commercial papers, money market funds, etc., are highly liquid instruments that can be generally redeemed within 90 days. Thus, capital invested in cash and cash equivalents is easily accessible to investors.
4. Real estate: This type of asset class focuses on plots, apartments, villas, commercial buildings, industrial areas, etc. The tangibility of these investments is a crucial characteristic that makes it different from other securities that exist only in virtual or dematerialised forms.

How asset allocation works

Let’s understand the working of asset allocation with the help of an example. Imagine a store that specialises in selling winter apparels like jackets, boots, scarves, gloves, etc. It also sells winter gears such as ice skates and skies. As a result, it does significant business around the winter season. However, come summer, the store tends to do zero business. Now the store decides to expand its range of products. They open a section where they sell all kinds of apparels which could be worn in warmer seasons as well. They even begin to sell other accessories such as regular roller-skates, skateboard, etc. Now, the store generates business in both winter and summer. What’s more, the store further decides to open several departments that sell books, groceries, furniture, electronics, etc. Now, once a tiny, little window store is a huge departmental store that does great business all-year around. Earlier, the entire business of the store depended on winter and the hope that they do not face any competition around that time. However, with a departmental store that sells all kinds of products all-year-around, the business now continues to run come rain or shine with much lower risk. Asset allocation works on a similar concept wherein the risks are minimized with the help of diversification of investments across asset classes.

Strategy for Asset allocation

In asset allocation, there are no hard and fast rules on how an investor should invest, and different financial advisors follow a varied approach. Following are some of the top mutual fund asset allocation strategies used to influence investment decisions:

1. Life cycle funds asset allocation
   Also known as target date asset allocation strategy, this strategy tries to maximise the returns on investment (ROI) of an investor based on factors such as the investor’s age, their investment goals, and risk profile. However, critics point out that this kind of portfolio structure is complex due to standardisation issues.
2. Age based asset allocation
   This asset allocation strategy takes the age of the investor into account. Under this strategy, financial advisors recommend subtracting an investor’s age from 100 to determine the percentage of funds that should be invested in equity mutual funds. The rest should be invested in other asset classes such as debt. For example, if you are 30 years old, then 70% of your investments should be in equity funds and the rest (30%) in other asset classes.
3. Constant weight asset allocation
   Also known as strategic asset allocation strategy, this strategy is based on the buy-and-hold policy. Under this strategy, if one asset class, for instance, stocks loses value, investors are recommended to buy more of it and vice versa. The goal is to ensure that the proportions of the asset classes do not deviate more than 5% of the original mix.
4. Tactical asset allocation
   This strategy addresses the challenges that might arise from a strategic asset allocation strategy over the long run. Hence, this strategy aims at maximizing short-term investment strategies. This flexibility adds a market-timing component to the investment portfolio, allowing an investor to join in economic conditions that are more favourable for one asset class.
5. Insured asset allocation
   Under this strategy, base asset value is established under which the portfolio should not be dropped. If the portfolio should ever drop, the investor is recommended to take the necessary action to avert the risk such as investments in risk-free assets like treasury bills (T-bills). This strategy is ideal for those investors who are averse to risk. For example, an investor looking for a minimum standard of living during their retirement period might find this strategy ideally suitable for their investment goals.
6. Dynamic asset allocation
   This is one of the most popular investment strategies. Under this strategy, an investor constantly adjusts the mix of assets based on the highs and lows of the market and also gains and loses in the economy. Under this strategy, you purchase assets that show signs of continued market gains and vice versa.

With asset allocation, the concept of ‘one size fits all’ does not apply. Every individual’s financial condition is different and requires a unique and different approach. In fact, an investor should regularly check their financial strategies and ensure that it align with their financial goals, risk profile and investment horizon. Remember, portfolios that have superior product selection and consistent asset allocation tend to outperform the market. If you are unsure about the opimal asset allocation to achieve your goals, you might consider seeking the services of an expert. Happy investing!