Asset allocation refers to an investment strategy that focuses on balancing the risks and rewards by distributing the assets in a portfolio based on the investment horizon, risk tolerance, and financial goals of an individual.
There are three main asset classes, namely, fixed-income, equity, cash and cash-equivalents. Each comes with different levels of returns and risk, and thus, the behaviour of each varies with time. Asset allocation takes into account these variations to maximize returns while minimizing risks.
Asset allocation is one of the most crucial decisions that you will have to make for a secure financial future. Even the assets known to generate the highest returns can be rendered useless if you are not prudent with asset allocation.
In simple words, choosing individual investment instruments is much less important than the way you allocate assets in bonds, equities, and cash and equivalents, which are the prime determinants of investment results. In fact, studies suggest that nearly 91% of the difference between the performances of two different portfolios can be explained by their asset allocation strategy.
New investment options are increasing by the day for investors. They provide new opportunities for increasing returns while managing risks. An asset allocation strategy makes the best possible use of diversification, which is one of the keys to risk management.
Asset allocation is mainly based on two factors, namely risk appetite and age of the investor. Let’s take a look at these two factors and their impact on asset allocation.
Asset allocation based on age is centred on the simple principle that your risk exposure should reduce with age. In this case, it is mainly denoted as the equity portion of a portfolio.
The thumb rule is to allocate debt funds in a proportion equal to your age. So, you will have to subtract your present age from a hundred to get your equity allocation. In other words, asset allocation should move towards debt funds from equity funds as an investor grows older.
For instance, you are currently 30 years old. So, your portfolio can have 70% equity funds, and the rest 30% should be distributed between cash and debt funds. On reaching 40 years, you will get to switch to equity-based balanced funds that invest about 60% in equity and the rest in debt.
Risk capacity and risk attitude are the two things that make up your risk appetite. Risk attitude refers to the psychological comfort of an investor with market fluctuations and changes in fund values. Risk capacity is related to the financial capability of tolerating losses in investments.
For instance, suppose a 30-year-old individual earns a good salary in a reputed company. But his portfolio mainly shows money market instruments and debt funds. You might call him a conservative investor. After all, his financial stability and age make him well-qualified for equity investments, but his risk attitude prevents him from going that way. His risk capacity might be high, but his risk attitude is low.
The rule of thumb in case of asset allocation is that your age is inversely related to your risk appetite.
So, as a young investor, you can expand your income by switching to better opportunities because even a few losses in the fund value can be replenished by you. But, when you are retired or old, your savings become the only source of income for you. This means you cannot risk losing savings that you have built over the years. Standard Chartered Fund Select suggests the top mutual fund picks for you, based on a comprehensive analysis of the market and in alignment with your risk profile. Check out now!
An asset allocation strategy need not be changed based on market circumstances, but there are times when it is advisable and appropriate to update the strategy. Changes to your return needs or risk tolerance indicate that it’s worth re-evaluating the asset allocation in your portfolio.
The ability to take financial risks can change significantly over the course of one’s life. Your risk tolerance might increase based on the following factors:
- Need for greater returns to meet your investment goals
- Greater emotional ability for accepting volatility
- Accumulation of increased value in your investment assets
Risk tolerance might also decrease when the above situations are reversed. Such changes in risk tolerance need to be accommodated in the asset allocation strategy.
As you go ahead with a financial plan, there might come a juncture where you understand that your return needs have been considerably altered. Higher return needs usually lead to assuming higher risks. You might need higher returns in the following circumstances:
- Getting lower returns on original investments than the initial plan
- Less future earnings than expected
- Lifestyle changes
- Increased after-retirement needs than initially projected
- Retiring sooner than planned
Similar to changes in risk tolerance, a reversal of any of the conditions mentioned above might lower your return needs.
Changes in return needs and risk tolerance mean that it is time to update the current asset allocation strategy. Finding a balance between the desired returns and risk is the constant aim of an asset allocation strategy.
Using the right asset allocation strategy places investment portfolios in a better position to handle the ever-changing market dynamics. When coupled with strong financial discipline, it can ensure that you inch closer towards reaching your financial goal each day, while having a solid grip on your investment risks.
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