What Is Asset Allocation and Why Is It Important?

Introduction:

In March – April 2020, amid the COVID-19 scare, stock markets plummeted nearly 50%. Simultaneously, gold, a traditional haven, delivered exceptional returns. Fixed income, which initially remained stable, later saw central banks cut interest rates. These scenarios are precisely why proper asset allocation is crucial. By investing in various asset classes, gains from others can offset losses if one performs poorly. But how do we employ asset allocation in our portfolio, and what are some strategies? Let’s find out.

What is Asset Allocation?

Asset allocation is a strategy for creating a diversified investment portfolio and managing risk and returns. It involves spreading investments across various asset classes, such as stocks, bonds, gold, and real estate.

Each asset class is initially assigned a set percentage of the total portfolio. Over time, the strategy may evolve. Some methods involve rebalancing to maintain the original allocations. Other approaches adjust allocations based on investor age, increasing allocation to safer assets like bonds and reducing exposure to riskier assets like stocks as the investor ages.

Asset allocation helps manage risk by spreading investments across different asset classes, reducing dependency on one type of investment. Based on financial goals and risk tolerance, it can also lead to better risk-adjusted returns. Additionally, asset allocation strategies assist in achieving financial goals by diversifying investments according to one’s risk-taking ability. 

Categories of asset classes:

Indian investors have four main asset categories to consider:

• Equities: This involves direct investment in listed companies, where you acquire short-term or long-term investment stocks. It’s a riskier option due to market volatility. You can invest in equities through mutual funds and individual company stocks.
• Fixed Income: These low-risk investments offer regular income over a fixed period. Options include FDs, money market instruments, and corporate and government bonds.
• Real Estate: Investing in properties is an option for appreciation and rental income, though it requires substantial funds. Real Estate Investment Trusts (REITs) offer a way to invest without owning physical properties, providing income through dividends and potential capital gains.
• Gold: Adding gold to your portfolio reduces risk through diversification. Gold prices often move inversely to stock markets, serving as a hedge against market volatility. Experts recommend limiting gold exposure to 5-10% of total investments.

Additional investment options include international equities, digital assets, infrastructure projects (via infrastructure investment trusts), and commodities like silver, cotton, and zinc (through ETFs). You can also turn to cash and cash equivalents, such as CBLO and TREPs, to provide essential liquidity despite yielding low returns. Investors and institutions utilize these short-term instruments like certificates of deposit for easy fund access and security. Whatever the combination of assets, asset allocation should align with your diversification strategy and investment goals.

Asset Allocation Strategies:

1. Strategic Asset Allocation:

Strategic asset allocation involves deciding and maintaining your portfolio’s right mix of asset classes. This mix is determined based on factors like your age and risk tolerance. Periodic rebalancing keeps the proportion of assets at predetermined levels.

For instance, with the NPS’s auto-choice option, investors can select an equity allocation ranging from 25% to 75% until they reach 35. After that, the equity portion is reduced annually by a fixed percentage. This adjustment aligns the NPS asset allocation with the investor’s age.

2. Tactical Asset Allocation:

Tactical asset allocation means adjusting a portfolio’s mix of asset classes based on market changes. The goal is to profit from short-term market trends in stocks and bonds. For instance, during a market decline, increasing the share of stocks in a portfolio can capitalize on lower stock prices. Later, when the market rebounds, selling these stocks at a higher price can yield greater returns. This strategy aims to exploit temporary market movements to enhance investment performance.

3. Dynamic Asset Allocation:

Dynamic asset allocation, like tactical asset allocation, involves adjusting short-term allocations of asset classes to respond to market changes. Unlike tactical allocation, which is manual, dynamic allocation uses automated systems driven by financial models. Investors seeking this strategy can invest in balanced advantage funds, also called dynamic asset-allocation funds, for managed portfolios.

4. Life-Cycle Funds:

In life-cycle or targeted-date funds, investors optimize ROI (Return on Investment) based on investment goals, risk tolerance, and age. This portfolio approach is intricate due to individual variations in these factors. 

For instance, if Theo’s original mix is 50% bonds and 50% stocks, his risk tolerance for stocks might rise by 15% after five years. Consequently, he might sell 15% of bonds and reinvest in stocks, changing his mix to 65% stocks and 35% bonds. This allocation can evolve according to investment objectives, risk tolerance, and age.

5. Age-based Asset Allocation:

The age-based asset allocation strategy bases your equity mutual fund allocation on your age. One common approach is subtracting your current age from 100 to determine your equity allocation. For instance, at age 25, allocate 75% (100-25) to equity and 25% to debt or other asset classes.

6. Insured Asset Allocation:

For risk-averse investors, insured asset allocation is the optimal strategy. This method establishes a minimum asset value for the portfolio. If the value declines below this baseline, the investor reacts to mitigate risk. Conversely, if the portfolio maintains a value slightly above the baseline, the investor can confidently manage assets through buying, holding, or selling.

Factors Affecting Asset Allocation:

Personal goals, risk tolerance, and investment horizon guide your portfolio distribution. Goal factors represent individual aspirations, influencing investment decisions based on desired returns or specific savings objectives. Risk tolerance reflects an individual’s readiness to withstand potential losses against potential higher returns. Risk-averse investors favor secure assets, while more aggressive investors accept higher risks for potentially greater rewards. Time horizon refers to the duration an investor plans to invest, often aligned with their investment goals. Long-term strategies may involve riskier portfolios, as economic dynamics could favor such investments over time. Conversely, short-term goals typically steer investors away from higher-risk portfolios due to the unpredictability of immediate returns. Understanding these factors helps you tailor your portfolios to match your unique circumstances and objectives.

Bottom line:

Proper fund allocation across diverse assets optimizes returns and reduces risk. Asset allocation varies per investor, depending on goals and risk tolerance. Strategies adapt to individual financial goals and investment horizons. Asset mix should adjust with age and changing financial objectives.One way to ensure the right asset allocation for your portfolio is to consult a SEBI-registered share market advisory. Their expertise will help you learn more about asset preservation and asset allocation based on your financial profile.

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