When it comes to investing, you can only rely completely on any single type of asset. Instead, it’s better to spread your money into different types of investments, like stocks, mutual funds, bonds, and real estate. It helps reduce the risk of losing all your money if one investment doesn’t do better.
In this blog, we will discuss asset allocation, the types of assets you can invest in, the key asset allocation strategies, and how you can choose an asset allocation strategy that is right for you.
What is Asset Allocation?
Asset allocation is the investment strategy to balance risk in which you allocate your money to multiple asset classes, such as equity, debt, stocks, and gold. The primary purpose of asset allocation is to ensure that your portfolio performs well under different market conditions. This can be done by ensuring you have a diversified portfolio of different asset classes, as no asset class performs well at all times.
Importance of Asset Allocation
Asset allocation is important for several reasons:
- Risk Management: By diversifying investments across various asset classes, you can easily reduce the risk in the overall portfolio, as the performance of your portfolio is not dependent on one asset class.
- Enhanced Returns: You are expected to earn better risk-adjusted returns if you allocate assets per your financial goals and risk tolerance.
- Achieve goals: Asset allocation strategies helps you in achieving your financial goals as it spreads your investments across different types of assets considering your risk-taking ability.
- Avoiding Concentration Risk: Spreading investments across different assets prevents overexposure to any single asset, reducing the potential negative impact of a poorly performing investment.
Different Asset Classes
The 4 main asset categories available to Indian investors are:
- Equities: Under the equity asset class, you directly invest in any listed company. In return for your investment, you receive shares of the company. These are considered more risky investments due to their volatility. Equity-oriented investments include equity mutual funds and stocks.
- Fixed Income: Fixed income asset class is considered low-risk investments, giving you a regular income over the investment period. It includes FDs, money market instruments, corporate bonds, government bonds, etc.
- Real Estate: Real estate can offer attractive returns through property appreciation and rental income. It includes investment in residential or commercial buildings, lands, etc. But to invest in real estate, you need a big corpus. Also, real estate investments are less liquid than other investments, as you can not sell them at any time or a fraction of them.
Another option is REITS (Real Estate Investment Trusts ), wherein you invest in real estate without owning any physical properties. You earn regular income through dividends/interest payouts and also earn potential capital gains at the time of selling it. - Gold: Having Gold in your investment portfolio is beneficial because it lowers risk through diversification.
Gold and stocks usually move in opposite directions. This means that when stock markets go down, the price of Gold tends to go up, and when stock markets rise, the price of Gold tends to fall. As a result, Gold acts as a hedge against volatility in the stock market. However, it’s important not to put more than 5-10% of your total portfolio in Gold.
But these are not the only asset classes that you can invest in. You also have the option of investing in asset classes like international equities, infrastructure projects (throughinfrastructure investment trusts), and even commodities like silver (through silver ETFs), cotton, zinc, etc. However, you can’t randomly choose to invest in any asset class. The choice of assets to diversify your portfolio and how much you should allocate would depend on your asset-allocation strategy. Let’s briefly understand what these strategies are.
Asset-Allocation Strategies
There is no one-size-fits-all approach to asset allocation, as every investor is unique regarding their investment goals, risk tolerance, age, financial responsibilities, etc. But apart from these investor-specific factors, external factors like market movements, changes in interest rates, etc., might necessitate a periodic change in the asset-allocation strategy. There are 4 key types of asset-allocation strategies:
Strategic Asset Allocation
Strategic asset allocation involves determining and maintaining an appropriate ratio of various asset classes in the investor’s portfolio. This appropriate mix of various asset classes in the investor’s portfolio is determined based on factors such as the investor’s age, risk profile, etc. In this type of asset allocation, periodic portfolio rebalancing is performed to ensure that the proportion of individual assets in the portfolio is maintained at the pre-determined levels.
For example, under the auto-choice option of the NPS, investors can choose the maximum equity allocation between 25% to 75% till 35 years of age. However, after the investor achieves 35 years of age, the equity allocation of the portfolio is reduced by a fixed percentage every year. Therefore, the NPS asset allocation is strategically changed as per the investor’s age.
Tactical Asset Allocation
The tactical asset allocation strategy involves tactically changing the proportion of different asset classes in an investor’s portfolio to take advantage of changing market conditions. The main aim of this is to benefit from relatively short-term bullish and bearish conditions in equity and debt markets.
An example of this can include increasing equity allocation in the investment portfolio for the short term during a market downturn to benefit from the lower prices of quality stocks. When markets recover later, these stocks can be sold at a profit to generate higher returns for the investor.
Dynamic Asset Allocation
Dynamic asset allocation is similar to tactical asset allocation as it also focuses on changing the short-term allocation of different asset classes to take advantage of changing market conditions. However, unlike tactical asset allocation, which involves buying and selling investments manually, dynamic asset allocation is performed using automated systems based on financial models. Investors who want their portfolios managed using dynamic-asset-allocation techniques can opt to invest in balanced advantage funds, also known as dynamic asset-allocation funds.
Age-Based Asset Allocation
Age-based asset allocation strategy considers your age as the key factor in determining your equity mutual fund allocation. Under this strategy, your equity allocation is determined by subtracting your current age from the 100.
For example: If you are currently age 25, then you can have 75% (100-25) equity in your portfolio, and 25% remaining can be debt or any other asset class.
Factors Affecting Asset Allocation
There is a belief that investors must follow standard rules for asset allocation and that the rules are the same for all investors. However, this is not true. Asset allocation varies from investor to investor.
So, how should you decide your asset allocation? Well, one of the most important factors is your risk profile. Every individual’s risk profile is different, and owing to this, the standard rule of asset allocation shouldn’t be used.
Understanding Your Risk Profile
To understand your risk profile, you need to understand three components that constitute your risk profile – risk appetite, risk capacity, and risk tolerance.
You might think of these terms as the same, but you must note that there is a difference between each of these.
- Risk appetite is how much risk you are willing to take.
- Risk capacity is how much risk you can take. Although you might be willing to take the risk on your entire capital, your current financial situation, including liabilities, dependents, age, and salary, might not allow you to do that. So, you need to consider these before defining your risk capacity.
- Risk tolerance is how much risk you can tolerate mentally. For example, if you invest in the stock market, where there are a lot of fluctuations, you must be mentally prepared to tolerate the risk.
Of these three components, risk tolerance is most critical while determining your asset allocation. That’s because you might have a high-risk appetite and risk capacity, but your risk tolerance will determine which asset classes and investment options you pick.
As you allocate assets based on risk tolerance, you must consider personal factors like your monthly income, expenses, age, financial liabilities, your dependents in the family, etc.
Need for Asset Rebalancing in Asset Allocation
Another important factor to consider with asset allocation is rebalancing. It refers to the buying or selling of assets in a portfolio to maintain a balanced level of risk.
For example, suppose your investment portfolio has 45% of your assets allocated to equity, 45% to debt, and the remaining 10% to gold. Now, assuming that the markets are performing well and you make profits on your equity investments, the allocation to equity in your portfolio increases to, let’s say, 52%. Now, because you earned profits on one asset class in your portfolio, the share of the other asset classes would automatically reduce. Since you have earned profits from your equity investments, you can now use those profits and allocate more funds to other asset classes in your portfolio that now have a lesser allocation in your portfolio. This rebalancing will ensure that the asset allocation in your portfolio is again balanced as you originally planned, thereby mitigating the risk.
Note that if you do not rebalance your portfolio, it will be skewed towards one particular asset class and this will increase the risk involved in your investments. For instance, if you favor equity investments, you would start investing more funds in equity. But this may eventually increase the risk involved in your investments.
How to Choose the Right Asset Allocation Strategy
We all have unique goals in life. They define our investment horizons as well as risk tolerance. Therefore, the ideal asset-allocation strategy must be customized to each of the unique needs. The asset mix for each goal should be aligned to risk tolerance, which can change over time due to factors like evolving goals, increase or decrease in income, etc. Therefore, you also need to periodically review your portfolio and rebalance it to ensure you are on track to reach your goal. Wouldn’t it be nice if you had some way to ensure that all this heavy lifting was done automatically? This is where having an ET Money Genius membership can benefit you.
The ET Money Genius membership gives you access to 6 customised strategies based on your risk tolerance and investment horizon. These 6 investment strategies allow you to invest in customised investment portfolios of mutual funds or stocks and ETFs uniquely suited to your investment needs. These customised investment portfolios ensure you are invested in the correct proportion in different asset classes like domestic equities, debt, gold, and international equities.
Beyond the initial investment selection, Genius will also use dynamic-asset-allocation strategies to determine the best time to enter into and exit from each asset class through one-tap monthly rebalancing of your portfolio. This allows Genius to increase your allocation in different asset classes or even bring it down to zero based on the prevailing market conditions. This way you are assured of optimal returns while never exceeding the overall risk tolerance of your portfolio.
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