While driving on a highway, you will often find vendors on the streets selling umbrellas and sunglasses. It’s an odd combination. After all, what’s the probability of buying both these items? Very low. If it’s raining, you buy umbrellas and if there is a clear sky, well you slip on sunglasses. But, buying both at one time is unlikely.
While buying both makes little sense for you, selling them makes ample sense for a vendor. Since he is catering to all weather conditions, and his sales keep ticking.
By diversifying the least associated product lines – the street vendor has reduced the risk of losing sales in a day.
is something like that.
What is its definition?
It is defined as anthat attempts to balance risk versus reward by adjusting the percentage of each in an , according to the investor’s risk tolerance, goals and time frame.
While it is aboutacross different classes, it is much more than mere of a .
First of all, let’s look at the majorclasses.
Traditionally speaking, there are three of them – equity, debt and cash. However, to that, you can also add real estate, precious metals (gold, silver etc) and alternatives such as art, coins and other collectables.
Historically, it has been seen that the correlation between equities and bonds have been low and they don’t move in the same direction. During the bullish phases of the market, usually, the bond yields flatten and vice versa.
Here, during the bear phase of 2007-2008, while equity was down by 55%, debt funds were up by 15% or more thanks to a rapid fall in interest rates (which results in appreciation of bond prices and).
Thus byin different that are least correlated; the investor’s could minimize risks of overconcentration while also capitalizing on potential market opportunities – just like the above street vendor. However, over the long run, it also affects the return potential – as you will read further.
What’s the ideal asset allocation?
There is no such thing as an ideal allocation. It can be 100% equities, 50% equity and 50% debt or 100% debt. It all depends on the financial goals, risk tolerance, andhorizon. Let’s take it one-by-one.
Goals could be long-term or short-term. Long-term goals are typically forand providing for children’s higher education, while short-term goals could be saving for an international holiday or owning a gadget.
for a long-term goal is usually equity-oriented. As a thumb rule, any that is not required for at least five years could be ploughed into equity funds, while the rest could be invested in liquid or short-term funds. With debt , you cannot expect to beat inflation (get about 6% annually) but with equities where the potential is to earn around 11% (as of 2021), patient investors can create inflation-beating wealth over the long-term.
Usually, the risk tolerance of an individual is difficult to gauge unless he has experienced a bear market. However, know that being conservative can also delay or compromise your financial goals.
So, arrive at anthat suits your various financial goals and horizon.
What if the stock markets soar and thegets tweaked. Let’s assume, you had an of Rs 1 crore – with 60% equity and 40% debt . Now a 20% rise in the stock market over the year, has increased the equity portion to 70% of the . Should you prune the exposure back to a 60% level?
There are essentially two ways in whichis managed. One is called the Strategic allocation, whereby the target allocations are maintained through periodic balancing. Here, an investor or her advisor will revisit the in a year or so and prune exposures to bring it to the targeted level.
Sometimes, advisors also suggest tacticalto capitalize on short-term opportunities based on market valuations and macro fundamentals. Here too, the attempt is not to time the market but to incrementally plough into based on its relative lucrativeness.
Will asset allocation ever need a change?
is not set in stone and will change with a change in your goals. An earlier than expected for instance could mean saving more or aggressively in equity to hit the target earlier. Similarly, a family life event could set a new goal which in turn could affect overall orientation.
matters more than stock or fund picking. By choosing an appropriate strategy and through its periodic , you can balance the risk and return of your .