Asset Allocation—The What, The Why, And The How
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Whether you are new to investing or a seasoned pro, you may already be familiar with some of the most fundamental concepts of sound investing. How? With the help of real-life, ordinary experiences. Some of the best pieces of investment advice come not from expansive knowledge of the intricate workings of markets, but a deep understanding of everyday human experiences. Asset allocation is no different. It derives from the fundamental human tendency to mitigate risks and prepare for uncertain outcomes.
What Is Asset Allocation?
Biology 101 tells us that a balanced meal is important for a healthy metabolism. Your diet can’t contain just proteins. You need to balance carbs, proteins, minerals, etc., to maintain a healthy lifestyle.
Similarly, asset allocation is the process of dividing an investment portfolio into different asset classes such as stocks, bonds, equity, gold, etc. The argument is that asset allocation helps investors minimise risk in their portfolios because each asset class has a different risk factor, growth and profits in correlation to the other.
The asset allocation optimal for you at any given stage in your life is largely determined by your time horizon and risk tolerance.
Importance of Asset Allocation
Here are three key reasons why asset allocation is vital for your portfolio:
Portfolio Stability: Different asset classes offer different investment cycles which have virtually no bearing on each other in terms of returns. This allows you to invest in assets so that even if one class takes a hit, your overall portfolio does not. A diverse portfolio across asset classes minimises risk and adds stability over your time horizon.
Risk v/s Reward: Risk is a double-edged sword. Or as they say in gym circles: no pain, no gain. Risk is an inherent property of every investment class, which is directly proportional to potential rewards. Asset allocation allows you to toe the line and find a balance so that fluctuations in markets do not jeopardise your portfolio.
Diversification: Diversification is the process of allocating your investments between several asset classes to minimise risk. It's the classic "don't put all your eggs in one basket" cautionary tale. Factors that cause one asset class to underperform may enable another asset class to thrive. People invest in a variety of asset classes in the hope that if one loses money, the others will compensate.
Asset Allocation Strategies
Here are three of the most popular asset allocation strategies:
Strategic asset allocation: This is based on target allocations for each asset class, where you maintain the allocation range regardless of market conditions. For example, assume the mandated allocation is 70% equity and 30% debt. If the stock market rises by 25% and debt gives a 6% return, the asset allocation will be 73% equity and 27% debt. Strategic allocation then calls for selling stocks and buying bonds to bring asset allocation to 70% equity and 30% debt.
Dynamic asset allocation: This strategy encourages you to adapt your allocation based on market conditions. For example, as equity valuations rise, you can reduce your equity allocations and increase debt allocations. And vice-versa when equity valuations go down.
Tactical asset allocation: Tactical allocation is the opportunistic middle between strategic and dynamic asset allocation techniques. Investors may deviate from their core strategies to capitalise on market opportunities. Tactical asset allocation calls for high investment knowledge and a sense of market timing.
Rebalancing is the process of returning your portfolio to its original asset allocation balance. Over time, some of your investments may drift away from your objectives, and some may grow faster than others. Rebalancing your portfolio ensures that one or more asset groups are not overemphasised, and it returns your portfolio to a comfortable level of risk.
Here are some ways to start the process of rebalancing your portfolio:
1. Sell investments from over-weighted asset categories and buy under-weighted asset categories' investments.
2. Buy fresh investments in asset categories that are under-weighted.
3. Adjust your contributions to the portfolio so that more money goes to under-weighted asset categories until your portfolio is balanced again.
Get Started with Asset Allocation
Here are some basic steps to start your allocation journey:
● Consult your financial advisor
● List down your financial goals
● Assess your time horizon and risk factors
● Invest in a suitable mix of asset classes
● Review your portfolio annually
It is nearly impossible for anyone to predict the direction in which any asset class will move at any particular time. Thus, it can help you to see your investment portfolio as a team of individuals (asset classes) who each contribute to a singular financial goal, instead of separate asset classes with incoherent strategies.
As Knute Rockne, the legendary American football coach once said, “I play not my eleven best, but my best eleven.”
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