When you think of your investment choices in terms of your financial goals the outcomes become a lot more productive. For example, if you want to invest for 8-10 years to provide for your child’s higher education, the investment product and asset choice will be very different than if you want to invest for a period of 3 years to plan for a housing loan down payment.
In the former, you have the advantage of time and can choose high return growth assets like equity. In the latter, your need is for the stability of return, given that the down payment is only a few years away and mostly non-negotiable. While one goal needs the benefits of equity, the other can be addressed through debt investments. This becomes an automatic asset allocation that is aligned well with your financial goals.
Risk, in this case, is the possibility that the asset class you are invested in is out of favour when you need to exit. You can invest across assets and within an asset class too, there will be categories that have varying risk-return dynamics. Having a mix of more than one asset in your investment portfolio cushions returns. For example, in times of high uncertainty, assets like equity tend to correct, whereas, gold comes in demand as investors flock to safety and gold prices often rise in such periods.
Your overall portfolio value gets protection from falling too low when you have a built-in asset allocation. Your strategic asset allocation is most likely a result of financial goals, but you could also have a portion of your investments according to your risk tolerance which will also require the right asset allocation.
Avoiding market timing
Timing the market means trying to buy at a price you feel is a good entry and sell when you feel markets are overvalued. This kind of tactical strategy may or may not work out as it’s hard to foretell which asset class will do well at what point in time and for how long.
Having an asset allocation strategy based on your goals and risk tolerance will get you closer to the expected return with a much greater probability than timing your market entry and exit. No one knew that fixed deposit rates would fall below 5% (post-tax) or that the equity market would return over 50% in 2020, yet it happened. Had you stuck you your asset allocation, both these outcomes would not impact your expected return.
Asset allocation is an important aspect of long-term investing, one that can’t be overlooked if your aim is to arrive closest to your expected return.