What is Asset Allocation?
Asset allocation is an investment strategy that aims to balance the risk and growth associated with investment schemes. It balances the risk and growth by allocating the total investment among different asset classes. These asset classes differ in terms of the category of risk and returns. Therefore, an asset allocation helps the investor to reduce the impact of risk to the portfolio, which exposes them to each asset class that has a correlation to one another.
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Importance of Asset Allocation
All the asset classes do not move at the same pace or same direction. Hence, having a proper mix is very important. Asset allocation helps an investor in reducing or instead managing the risk better. The investor can achieve this by diversifying his or her fund into different assets with different risk levels. Also, this gives a potential to earn returns while lowering the risk through diversification. For instance, An investor invests in equity funds and liquid funds. Now with equity funds being more volatile, liquid funds can help balance when the market acts wildly and becomes too volatile.
How does Asset Allocation work?
Asset allocation refers to an investment strategy for their portfolio having different asset classes like equity, fixed income and cash or cash equivalents. Each asset class may perform differently when the economy moves in a direction. As the economy goes up, some assets might move up, while some may be flat or even go down, depending on the circumstances. In simple words, different asset classes will always provide different returns.
Investing in different asset classes allows investors to build a portfolio. They can mix and match the quality of asset class depending on their understanding of risk, investment horizon and financial goals. Also, this can make a portfolio less volatile and potentially achieve the same or better returns than investing in a single asset class portfolio. Therefore, asset allocation takes advantage of diversification to reduce risk.
For instance, if you have 30 years to retirement, you can afford to take more risk in exchange for higher returns by investing most of the portfolio in the equity asset class.
Types of Asset Classes
An asset class is a grouping of different investment instruments that show similar characteristics. These investments in an asset class tend to act in a similar manner in comparison to other investments. Also, a composition of different asset classes helps for asset allocation in a portfolio. The following are the different asset classes or categories –
Equity or stock represents ownership of a part of a company. Thus, a stockholder is eligible for its assets and profits to the proportion of stock they own. Equity has gained popularity over the last decade. Equity can further be classified as large-cap, mid-cap and small-cap based on market capitalisation. Also, the equity is sensitive to the stock market movements. They tend to do well in a growing economy and poorly in a weak one.
This is the most popular and oldest investment option. They include corporate bonds, government bonds, government schemes, etc. These instruments are issued for a fixed maturity period and pay fixed interest payments to their investors until maturity. Moreover, they are relatively stable than equity as the performance of the bond majorly depends on the quality of the issuer.
Cash and Cash Equivalents
They are also known as money market instruments. This asset class is best suited for short term investment duration. They include treasury bills, commercial papers, certificates of deposits, etc. The primary advantage of this asset class is they are highly liquid instruments that can be redeemed within 90 days. Because of high liquidity, they are considered a safe place for investment.
This type of asset class comes in many forms where investors can make money on the price appreciation. Tangibly they focus on plots, commercial buildings, apartments, villas, etc. Also, you can buy from real estate investment trusts in a dematerialised form which may be tedious work.
It is a very popular investment in India. Many investors use gold as a hedge or a store of value in their portfolio. This asset class performs well when the economy is weak or in trouble, and the other asset classes do poorly.
The recent trend is also to include highly speculative investments like futures and options, cryptocurrencies into an asset class or mix. However, this is highly risky.
Factors affecting the Asset Allocation
The process of determining the right mix of asset allocation depends on the individual’s portfolio, which is very personal. While making an investment decision, the asset allocation decision is influenced by various factors, which are discussed below:
Time horizon is the number of years or months the investor will invest to achieve a particular objective. Different investment horizons entail different risk tolerance levels. For instance, a long term investment strategy may prompt an investor to invest in a high-risk portfolio as the market dynamics are uncertain and may change in favour of the investor. On the other hand, investors with short term goals may not invest in a riskier portfolio.
Risk tolerance refers to the investor’s willingness or ability to lose a given amount of their original investment in anticipation of potentially higher returns in future. For instance, investors with a high-risk tolerance level are likely to risk most of their investments in anticipation of higher returns. In contrast, investors with low-risk tolerance levels withhold their portfolios for more secure assets that can preserve their original investment.
Investment objective refers to an individual’s aspiration to achieve a given level of return or saving for a particular reason or desire. Some of the investment objectives can be children’s education, travelling, retirement, marriage, etc. Therefore, based on the investment objective, the investor takes risks and invests.
Asset Allocation Strategies
In asset allocation, there is no fixed rule on how an investor can invest, and also each financial advisor follows a different approach. The following are some of the investment strategies that influence investment decisions:
Life Cycle Funds Asset Allocation
It is also referred to as a target-date asset allocation strategy. Under this strategy, it tries to maximise the returns on investment (ROI) for the investor based on factors like their age, investment goals, and risk tolerance level. However, this portfolio structure is complex due to standardisation issues. Every investor has a unique preference across the three factors.
Aged Based Asset Allocation
This strategy considers the investor’s age for an investment decision. The financial advisors recommend investors make an equity investment decision based on the deduction of their age from a base value of 100. The remaining portion shall be invested in other asset classes. For instance, if you are 30 years old, then 70% of your investment should be in the equity class and the remaining 30% in other asset classes.
Constant Weight Asset Allocation
It is also referred to as a strategic asset allocation strategy that is based on buy and hold policy. In other words, if a stock loses its value, investors buy more of it. However, if the prices increase, they should sell a bigger proportion. The objective is to ensure that the proportions of the asset class do not deviate more than 5% of the original mix.
Tactical Asset Allocation
This strategy addresses the challenges that may occur from strategic asset allocation strategy over the long run. Thus, this strategy aims at maximising the short term investment strategies. As a result, it adds more flexibility in coping with the market dynamics, which allows investors to consider economic conditions that are more favourable with one asset class.
Insured Asset Allocation
This strategy is ideal for investors with low-risk tolerance levels. It involves setting up a base value from which the portfolio should not fall. If it falls, investors must take necessary actions to avert the risk by investing in risk-free assets like treasury bills, etc. For instance, an investor with a minimum standard of living during retirement can find this strategy more suitable for their investment goals.
Dynamic Asset Allocation
This is one of the most popular investment strategies. This strategy enables investors to adjust the mix of their assets based on the highs and lows of the market and also gains and losses in the economy. Therefore, this strategy allows investors to purchase assets that are in line with the market gains.
To conclude, one asset allocation does not fit for all. Every individual’s financial position is different and requires a unique approach. In fact, every investor must monitor their financial strategies regularly. This ensures that it is aligned with their financial goals, investment horizon and risk profile. It is essential to remember that your portfolio is unique, and consistent asset allocation tends to outperform the market. If you are unsure about the optimal asset allocation, you can consider seeking our services at Scripbox.