If you ask a wealth manager, what is this thing called asset allocation they will tell you that it is an approach to investing where you decide the amount to be invested in different assets based on your long and short-term financial goals.
It may sound very technical, but in reality, many of us are already making such decisions. If you simply look at the aggregate investments you hold, you are sure to find more than one type of asset and within that more than one security. For example, you may own some mutual funds, equity and debt, some fixed deposits, and may have also invested in real estate.
But asset allocation is not something you should leave to chance. When done right, asset allocation will bring your return outcome that much nearer to what you need. Here is why:
1. Asset allocation spreads your risk – You may have a natural affinity to a particular type of investment. Some of us like equity more than real estate and others prefer fixed income. However, intuitive investments can lead to over-reliance on one type of asset which can leave you exposed to risks.
For example, having too much in fixed return assets may give you safety but you risk low real returns during inflationary times and insufficient long-term returns. Similarly, over-allocation to equity will leave your short-term investments goals vulnerable to the short-term ups and downs of markets.
2. It helps you define your investment objective – Investing regularly stems from some future need for money. These could be short-term needs like paying for education fees, or a down payment for a house. Alternatively, it could be long-term wealth creation for retirement. Consciously combining equity and fixed income investments in a manner that suits your financial goals is a better approach to managing safety and growth or your portfolio’s risk return framework.
For example, your long-term investment goals are better catered to buy wealth creating assets like equity. On the other hand, for funds that you need in three to six months, allocating to fixed income assets makes more sense. By doing this, you can also stay away from or not allocate to assets that don’t add value to your overall investment goals.
3. Asset allocation eliminates ill-thought market timing – Noise around one asset class in the media or a sudden price rise can tempt you to join the band wagon.
However, market prices for assets are driven by several factors irrelevant to your financial goals. Chasing returns, thus, may well backfire if the market environment becomes negative.
You may end up making poor returns in the short term and get turned-off by an asset type completely. Sticking to asset allocation regardless of the market environment, helps you achieve your long as well as short-term returns in a logical and stable manner.