What Is Asset Allocation & How It Can Reduce Your Investment Risk

Imagine playing eleven in a cricket match where the entire team is comprised of batsmen? Not possible, you will say. And we agree. After all, you need the right mix of players with different skill sets to win the match, isn’t it?

Like cricket, you need the right mix of investment options to meet your financial goals & secure your financial future. That mix, in financial terms, is known as “asset allocation”.

In this post, let’s understand what asset allocation is and how it can reduce your investment risk. We also share a step-by-step guide on how you can do asset allocation for your investments.

What is Asset Allocation

Before understanding asset allocation, we need to understand asset classes. An asset class is a category of investments having the same risk/return characteristics. You can map all your investment to the respective asset class.

See the table below for some examples of investments mapped to the respective asset class:

Asset Class Examples of Investments 
Equity Stocks, Derivatives, Exchange Traded Funds (ETF), Equity mutual funds, ELSS, the Equity portion of NPS, Private Equity etc.
Fixed Income Debt Mutual funds, Fixed Deposits, Bonds, NSC, Post Office Investments, Debt portion of NPS, PPF, VPF, EPF etc. 
Commodities Physical Gold, Silver, Gold Bonds, etc.
Real Estate House, plot, land, real estate investment trust etc. 
Cash  Cash on hand, cash loans given to friends etc. 

Asset allocation works on the principle that each asset class behaves differently in a given market, with little or no correlation with other asset classes.

For example, when equity markets are going high, you will find that gold is giving a lesser return. Conversely, when the equity markets are going down, you will see that gold delivers a spectacular return.

Asset Allocation uses the above principle to create an asset mix as per the time horizon of your financial goal & your risk tolerance. For example, suppose you decide on a mix of 60:40 in equity & debt (fixed income). In that case, it will mean you will have 60% of your money in equity investments & the rest 40% in debt investments.

How you can benefit from Asset Allocation

Asset allocation is a powerful tool to reduce risk in the investment portfolio. It helps you in the following ways:

  • Helps you “diversify” your total investment portfolio into multiple asset classes. This will help not all investments fall in value in a falling market. By doing this, you minimise your investment risk.
  • Over time, the return from your investment portfolio as a whole is a lot more stable, instead of sharp ups & downs. Benefit: Better sleep at night…. priceless, isn’t it?
  • You start following a “process” & don’t allow yourself to be swept over by emotions like greed & fear.
  • By following asset allocation, you “automatically” end up booking profits when markets are high & buying cheap when markets are low. This way, you save yourself from the pressure of timing the market.
  • You significantly increase your chances of achieving your financial goal safely.

Step by step guide to asset allocation for your investments

Find below a list of easy steps that you can follow to risk-proof your portfolio through asset allocation:

Step #1: Make a list of your financial goals: when you need the money and how much.

Step #2: For goals due in the next 5 years (i.e., short term goals), keep allocation 100% into fixed income asset classes.

Step #3: For other goals, check your risk profile. Ask yourself: how much percentage of my total investment can I invest in equity and still sleep peacefully at night? Assume it is 50%. So, your ideal asset allocation is 50:50 into equity & fixed income.

Step #4: Create a separate investment bucket for each financial goal. Make an inventory of all your investments. Tag them to your financial goals.

Step #5: Check the asset allocation % for each financial goal. See if it is aligned to the ideal allocation as finalised in Step #4. If not, buy/sell investments to align with the ideal allocation (this is known as portfolio rebalancing).

Step #6: For monthly savings, make an investment plan aligned with your ideal asset allocation & start investing.

Step #7: Every year, check the asset allocation for each financial goal & rebalance the portfolio as needed. This is very important.

Tips on Asset Allocation:

Below are some tips to help you fine-tune your asset allocation:

  • Consider only your “investment assets” for allocation purposes. Do not include personal assets like the house that you live in, car, jewellery etc.
  • Decide in advance on the frequency of rebalancing. Rebalance only on that date. Ignore all market movements.
  • Do also consider the tax angle while doing portfolio rebalancing. For, e.g., if you sell debt mutual funds before 3 years, you will have to pay short term capital gains tax. Don’t rebalance very frequently.
  • If the above process seems overwhelming for you, don’t hesitate to get help from a financial expert.

Conclusion:

Asset Allocation is a wise investment strategy. It helps you reap the benefits of high-risk asset class like equity & reduce your risk. It also saves you from making emotion-driven decisions & instils necessary discipline by providing a rules-based framework.

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