Everyday Money: What is Asset Allocation? Asset allocation helps to balance risk and returns in investment portfolio
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Asset allocation is an investment strategy wherein the investor decides how much money has to be apportioned across asset categories. This process helps the investor to balance risk and returns by diversifying across different assets, such as equity, bonds, gold, etc.
Why asset allocation?
All asset classes have a different degree of risk and returns. Also, all the asset classes move differently at a given point of time. For instance, in the current choppy markets, equity is the worst hit, whereas debt is less affected due to market movements. Gold, on the other hand, is booming as it is considered as a safe haven during a recession. For this reason, if your investments are spread across different assets, you will get best risk-adjusted returns in your portfolio.
How to do asset allocation
There is no single asset allocation strategy that every investor can follow. It varies according to the individual's risk profile, type of financial goal and investment horizon.
Let us understand this with an example where an investor wants to invest for the long-term goal of his kid's college education that is 15 years away. He can have up to 95 per cent allocation in equity for the first 10 years, since he has a long time to ride out the market volatility.
Equity has growth potential in the long term. Historical data shows that equity has delivered average annualised returns of 15% in the last 10 years. But, equity is highly volatile too, so the investor's risk tolerance has an important role here. A moderate investor can allocate 60% in equity, 35% in debt and 5% in gold. A conservative investor who cannot stomach market volatility at all should invest in the safety of fixed deposits and PPF, despite the long goal horizon.
Similarly, someone who wants to save for a foreign vacation next year should put his savings in liquid funds, fixed or recurring deposits or ultra-short term debt funds and stay away from equity completely, even if he is an aggressive investor. For a short-term goal, the objective is not to chase returns but to set aside money regularly so that it doesn't get spent.
When to review asset allocation
Asset allocation should be monitored and changed as per change in investment horizon.
As you approach the goal, the focus should shift on capital protection. If you have been heavily invested in equity, you should start moving to debt when the goal is less than five years away because a downward movement in markets when you are close to your goal can wipe off your accumulated corpus significantly.
You may also want to review your allocation if your financial situation or the goal has changed. But, don't change your asset allocation according to market movements.