What is asset allocation and why is it important when investing?

Have you ever wondered how seasoned investors create their investment portfolios? How do they decide the investment amount for different assets like equities, bonds, real estate, gold and so on? How do they balance the risk that their portfolio is exposed to while maximising the return potential? This entire process can be labelled as asset allocation.

In this article, let’s see what asset allocation is and how it works. We’ll also look at some asset allocation examples and the factors that can affect it.

• Table of contents

• What is asset allocation?
• How asset allocation works
• What is asset allocation in mutual funds?
• Asset allocation example
• Importance of asset allocation
• Age-based asset allocation
• 4 factors that can affect asset allocation in your investment portfolio

What is asset allocation?

Asset allocation is the process of dividing an investment portfolio across different asset classes such as stocks, bonds, real estate, cash, and commodities. It is based on the idea that different assets have varying levels of risk and return, and by diversifying your investments, you can mitigate the overall risk of your portfolio and optimise the return potential by investing in a mix of asset types that respond differently to market conditions.

How asset allocation works

Now that you know the asset allocation meaning, let’s take a more detailed look at how it works. Here are the key steps involved:

• Identify investment goals: Define your financial goals, whether they are retirement, wealth accumulation, car purchase etc. This will guide you in choosing the types of assets for your portfolio and how aggressive or conservative your investment strategy would need to be.
• Assess risk tolerance: Understand your comfort with risk. Stocks offer higher returns but come with higher volatility, while bonds are relatively stable but offer lower return potential.
• Select asset classes: Choose the asset classes from equities (stocks), bonds, cash, real estate, and commodities based on your goals and risk tolerance for your portfolio.
• Rebalance periodically: As markets fluctuate, the value of your assets will change. Rebalancing ensures that your portfolio stays aligned with evolving goals, risk profiles and market conditions.

What is asset allocation in mutual funds?

Many mutual fund schemes also diversify across asset classes to balance risk and reward potential, based on different risk appetites and investment objectives. In simple words, asset allocation in mutual funds refers to the distribution of investments across different asset classes like equities, debt, and gold within a mutual fund scheme.

Asset allocation example

Suppose you are an investor with a five-year investment horizon who can tolerate some risk but seek a balanced portfolio. You decide to allocate your Rs. 5 lakh investment as follows: 60% in equities (= Rs. 3 lakh), 30% in Fixed Deposits (FDs) and bonds (= Rs. 1.5 lakh); and 10% in gold and cash (=Rs. 50,000).

Here, a large part of your investment is in equities, for higher growth potential over the long term. Then, you have balanced the risk in your portfolio with bonds for stable and regular returns. Finally, you have kept some cash for liquidity needs and invested in gold that can act as a hedge against inflation and market downturns.

Importance of asset allocation

The importance of asset allocation cannot be overstated. It offers the following advantages:

• Minimises emotional decisions: It helps create a diversified portfolio with a clear allocation strategy. Therefore, investors are less likely to make impulsive decisions during periods of market volatility.
• Helps balance risk and return potential: A well-diversified portfolio with proper asset allocation mitigates the risk of all your investments performing poorly at the same time.
• Optimises long-term growth potential: It helps investors combine higher-risk assets with relatively stable options. Moreover, asset allocation allows for adjustments based on changes in the market and personal circumstances so that your portfolio can be aligned with your evolving goals and financial situation.

Age-based asset allocation

A popular approach to asset allocation is based on the idea that younger investors can afford to take more risks while older investors should gear more towards conservative assets. The reasoning is that younger investors typically have a longer time horizon to recover from market volatility, while older investors need to focus on relative stability of capital as they approach retirement.

A common rule of thumb for age-based asset allocation is the "100 minus age" strategy.

If Seema is a 30-year-old investor, she can allocate up to 70% of her portfolio to equities and equity-related instruments (because 100 - 30 = 70) and the rest to bonds, FDs, gold or other relatively more stable assets. As Seema grows older, she can gradually reduce her equity exposure and increase investment in fixed-income assets like bonds to mitigate the risk factor given her diminishing investment horizon.

However, these guidelines should not be used as a replacement for professional financial advice. These are generic suggestions that do not take personal circumstances, investment objectives and market conditions into account.

4 factors that can affect asset allocation in your investment portfolio

• Risk tolerance: Personal comfort with risk is one of the most significant factors. Some investors prefer high-risk, high-reward potential strategies, while others may seek lower risk options with modest return potential.
• Investment horizon: The time you expect to keep your money invested plays a major role in asset allocation. Longer time horizons can potentially be suited to higher equity exposure, as there is more time to ride out market volatility.
• Economic conditions: Macroeconomic factors, such as inflation, interest rates, and economic growth, can impact asset returns and influence allocation decisions.
• Personal circumstances: Life events like marriage, children, or a career change may lead to adjustments in financial goals, which in turn may alter your asset allocation.

In conclusion, asset allocation is a powerful tool for investors seeking to build a balanced, diversified portfolio that matches their financial goals and risk profile. A well-designed asset allocation plan enables investors to mitigate volatility and cushions against market fluctuations. Whether you are just starting out or adjusting an existing portfolio, mastering the art of asset allocation can be key to your investment success.

FAQs:

What is asset allocation and why is it important?

Asset allocation is the process of diversifying investments across various asset classes such as cash, mutual funds, real estate, bonds, etc. Asset allocation helps investors manage market volatility while optimising investment returns to achieve their financial goals.

How does asset allocation differ from diversification?

Both asset allocation and diversification offer investors a chance to mitigate risks while optimising the return potential. Asset allocation is the strategic distribution of investments across different asset classes, while diversification refers to spreading investments either within or across asset classes.

Can asset allocation strategies change over time?

Yes, asset allocation of investors may need adjustment as their financial goals, risk tolerance, and investment horizon evolve over time. This may involve redistributing assets or buying and selling them to rebalance the portfolio.

What factors should I consider when choosing an asset allocation strategy?

When choosing an asset allocation strategy, take your financial goals, risk tolerance, investment horizon, age and liquidity needs into consideration. Additionally, you must also evaluate your understanding of asset classes, prevailing market conditions, and the ever-changing tax implications to create a balanced portfolio.

Can you provide an example of a balanced asset allocation strategy?

A balanced asset allocation might consist of 60% in equity; 30% in fixed income like bonds and FD; and the remaining 10% in gold, cash or cash equivalents. However, asset allocations examples will differ for everyone based on their age, financial goals and risk tolerance.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.