Mr. X recently started working with a multinational company after completing his MBA. Always striving to be independent and a self sustained individual, he wanted to start investing for his future needs without relying too much on his family. A large number of investment options made him confused. Everyone he asked for help suggested a different investment strategy. While his parents advised him to invest in a fixed deposit which was secure and will offer assured returns, his colleagues recommended him to invest in mutual funds. Some of his friends suggested that since he was young and had no responsibility on his shoulders to sustain other people, this was the right time to invest in the high-risk equity market.
Just like Mr. X, many of today’s investors face this dilemma of choosing the right asset allocation for their investment. One of the many fundamental reasons why a lot of investors fail to reach their desired goals and returns is the wrong selection of asset allocation for their investment.
Let’s understand what asset allocation actually is-
Asset allocation is nothing but a strategy that will help you balance the risks and rewards involved in investing. Essentially, it is a process of dividing your assets between different asset classes based on your risk profile, investment horizon and the goals that you want to reach. The typical asset classes that are part of the allocation are equity, fixed-income instruments, cash, real estate etc.
Since each asset class carries its own unique risks and reward opportunities, having a balanced asset allocation means covering all bases of high risk and low risk to attain a well-balanced and diversified portfolio for investment.
Factors affecting Asset Allocation:
Asset allocation is a very personalized thing and works differently for different individuals. Asset allocation can be planned to keep in mind the following factors:
- Age of the investor
- Amount available for investment
- Timeline of investment planned by the investor
- Number of dependants
- Overall financial goals
- Risk appetite
- Strategic Asset Allocation:
Strategic Asset Allocation aims at creating an asset mix that provides the balance between the expected risk and returns over a long-term time horizon. This is the most common type of allocation where investor simply picks and chooses different asset classes that will hopefully minimize risk with offsetting investments that generate a return within a specific range. For instance, you can strategically offset some of the risks from stocks by adding some safer investments such as bonds or cash equivalents.
The essence of this strategy is regular rebalancing. Rebalancing your portfolio at least once a year minimises the risk of deviation from the desired targets. Over time, either stocks or bonds will outperform the other and make you overweight in one area and underweight in another. By rebalancing back to your target you’re effectively taking some of your profit by selling high and reinvesting it in the asset that is lagging, therefore buying low.
Let’s understand the concept better through an illustration-
Suppose Mr. X has ₹5,00,000 in his portfolio and his target asset allocation is 60% in equity, 30% in debt and 10% in cash. Which means, the amount invested in equity will be ₹3,00,000, a debt will be ₹1,50,000, and cash will be ₹50,000. Now one year down the line, equity has grown by 12%, debt by 6% and cash by 4%. As a result, the new composition will be: equity- ₹3,36,000, debt- ₹1,63,500 and cash- ₹52,000. The overall value of the portfolio will be ₹5,51,500.
According to the target allocation, the portfolio value will be allocated as:
The following table will help you to understand the adjustment done to bring back the portfolio to its target allocation:
From the above table, it is clear that equity worth ₹5,100 has to be sold, debt instruments worth ₹1950 has to be bought and cash has to be raised by ₹3,150 to bring the portfolio to its target allocation.
- Tactical Asset Allocation:
Tactical Asset Allocation strategy is a more active approach that tries to position a portfolio into those assets, sectors, or individual stocks that show the most potential for gains. By adding market timing component to the portfolio, it allows you to take advantage of the economic conditions which are more suitable for a particular asset class over the other.
The idea is to switch your asset allocation when conditions indicate that one asset might soon outperform another. Rather than focusing on picking particular investments, the idea is to focus on an entire asset class or sector at one time.
For example, if stocks are dropping, and offering a good bargain, it might be worth it to shift to more stocks in order to buy when valuations are low. That way, you get more returns. Later, as valuations increase, you can shift your asset allocation, selling for profits since you bought while prices were low.
- Insured/weightage Asset Allocation:
In Insured asset allocation strategy, you create a base portfolio value below which you are allowed to drop the portfolio. Until the time portfolio’s return is above its base value, you can actively manage the portfolio and try increasing the value of the portfolio as much as possible.
But in case, the value of the portfolio drops the base value you can invest in risk-free assets to fix the base value.
- Dynamic Asset Allocation:
Under this strategy, you constantly keep changing your asset allocation in order to get the best returns. This is generally not recommended for individuals as the cost of managing such an asset allocation will be very high.
Asset allocation as an investment strategy works effectively because it enables you to invest in different asset classes and each asset class contains different possibilities of risk and growth. If one particular asset class fails to produce growth, the rest will make up for it. Asset allocation provides you the following benefits:
- Less investment risk: The most important benefit of asset allocation is that it reduces your overall risk in investment as growth prospects are not limited to one particular asset only – rather to a plenty of asset classes. You don’t have to depend on a single asset class for your returns.
- Protection from market unrest: Well-planned asset allocation and rebalancing will safeguard your financial growth even during economic unrest. Since you are investing in different asset classes, loss in one class of asset will not hamper your overall and long-term growth.
- Increased goal orientation: A well-allocated portfolio helps an individual to efficiently achieve his financial goals without much burden. It helps in achieving financial security as well.
- Stability: Asset allocation helps you stabilize your returns over a period of time.
A popular myth:
The most popular myth is the age-based asset allocation. Here, you need to make asset allocation based on your age. For example, if you are 30 years old, then you put in 60% in equities, 30% in debt and the rest you keep as cash.
This strategy is totally wrong for several reasons. Firstly, it doesn’t take into account your risk appetite. If you have a low-risk appetite, then pure equities might be all wrong for you. Secondly, it doesn’t take into account the financial situation of the person. For instance, according to the strategy, if you are 60 years old, you will invest 30% in equities which will be quite high, given that you might have retired by that time and might not have a steady (or any) income. The third and most important thing that this strategy ignores is the financial goal that a person wants to reach. For example, you want to save for a car down payment and need it in the next three years. Being a 30-year-old, according to this method, you would have invested 60% in equities. You are actually putting your capital at risk and the time horizon is small. For this goal, you need to have more money in debt.
What should you do?
First, you need to create a financial plan based on your goals. Then, have your asset allocation set based on the goals and the time horizon to meet those goals. For example, if you are saving for your retirement, you can have as much as 80% of your investments in equities. However, if the goal is buying a house in the next five years, the equity portion should be much lesser. And of course, you need to keep an eye on your asset allocation so that it doesn’t get out of hand. And if you are unsure, always get the help of a financial expert. It’s your money after all and you do want to get the best out of it, right?