People investing in mutual funds or other financial instruments these days often come across a term called Asset Allocation thrown at them time and again without necessarily understanding the true essence of the term.
Asset allocation involves dividing ones portfolio into different asset classes: stocks, bonds and cash; these being the traditional asset classes. Other alternative assets classes which are also options for investments are commodities, real estate, derivatives, insurance, private equity etc. For the simplicity of understanding and illustration, we will stick to the traditional asset classes in this article.
Benefits of Asset Allocation Simplified:
Asset Allocation is an investment strategy which aims at investing in different assets classes (groups of similar financial instruments which tend to give similar returns) that helps in balancing the risk and returns in a portfolio in accordance to the investor’s goals, risk tolerance and investment horizon.
Let us take a simple example of a street vendor who keeps sunglasses, caps,umbrellas and raincoats in his stock to sell.On sunny days he ends up selling more sunglasses and caps - on rainy days he sells umbrellas and raincoats. He also keeps some helmets and seat covers which bikers / passersby who may need at some point. What is he doing? He is stocking all these items by allocating his assets into different kinds of items. This diversification helps him mitigate the risk of “no sales” during rainy season had he kept only sunglasses in his “portfolio”. He is increasing his product line to de-risk himself from being over dependent on just one product.
Asset Allocation works on a similar fundamental concept.
Process of Asset Allocation:
Asset allocation involves dividing ones investment portfolio among different asset classes, but the process of determining the mix or the ratio of the asset categories is a very personal one which is also dependent on ones goals, risk appetite and the time horizon to stay invested.
One needs to define his or her financial goals for eg., buying a house ,higher education for children or retirement planning.
Then one need to also assess what is the amount of risk he is willing to take or is capable of tolerating.
And then the time frame that one would like to stay invested.
A simple illustration would be if one has retired, which means there is no regular income flow that is coming, it is advisable that the investments are in fixed income funds, bonds and cash as it is more stable. This would aim at preserving the corpus of money which is earned over the years. However, if you have 25 years of investing and a long term goal of your child’s higher education, you may want to invest a larger share in equity /equity funds like 60-70% in Equity, 20% in Debt and 10% in Cash.
Asset Allocation Changes with Time and Needs to be reviewed:
While asset allocation, once done, reduces the need in a portfolio from daily monitoring, it does not mean that one does a onetime asset allocation and then just forget about it. It is always advisable to review your portfolio either with your financial advisor or personally at regular intervals and may be adjust your asset allocation from time to time to ensure you meet your financial goals.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.