
Asset allocation, in simple words, is the diversification of your financial assets into different classes like Equity, Debt, Gold, International equity, Real estate, etc. A portfolio should be balanced and well-diversified within the asset classes such that it should be able to provide good upside participation with minimal downside risk.
Several asset types can be included in an asset allocation strategy. Here are a few common asset types and the role they can play in an asset allocation:
- Stocks: Stocks represent ownership in a company and can provide the potential for growth and income. They can be a more risky asset class, but may also have higher potential returns over the long term.
- Bonds: Bonds are debt instruments that are issued by companies or governments. They typically pay a fixed rate of interest and can provide a source of income. Bonds tend to be less risky than stocks but may also have lower potential returns.
- Cash: Cash includes assets like savings accounts, money market funds, and short-term certificates of deposit (CDs). These assets are considered to be low-risk and can provide a source of liquidity. However, they may also have lower potential returns compared to other asset classes.
- Real estate: Real estate can include investments in physical property, such as rental properties, or investments in real estate investment trusts (REITs). Real estate can provide the potential for income and appreciation, but may also have higher volatility and a longer investment horizon.
- Commodities: Commodities are physical goods that are traded on markets, such as gold, oil, and agricultural products. They can be a more volatile asset class and may be more appropriate for investors with a higher risk tolerance.
In asset allocation, the specific asset types and their allocation will depend on the individual investor’s risk tolerance, investment goals, and time horizon. It’s important to consider these factors and diversify the portfolio among different asset types to manage risk and potentially improve returns.
Most people follow the age-old formula to decide the asset allocation for their investors, which is commonly known as Equity allocation=100 – Age, i.e. A person aged 70 should not have more than 30% percent of his assets in stocks, or a 30-year young investor should have no more than 70% in stocks.
This means that a young investor can be aggressive while a senior investor, in his retirement, should be low on Equity. But a problem with this approach is that it ignores the goal-based investing approach and the financial situation of the investor. A person who has an important financial goal coming up cannot go bullish on Equity for the funds allocated towards that goal. Inversely, if a senior citizen has arranged the income for his household needs in the coming future and provided that he is otherwise financially secure, he can still stay high on Equity. He can enjoy a fun ride with volatility.
In short, Asset allocation is the process of dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. It is an important aspect of investing because it can help manage risk and improve returns.
Here are a few reasons why asset allocation is important:
- Diversification: By allocating assets among different asset categories, investors can diversify their portfolios and reduce the risk of having all their investments in one asset class. For example, if an investor has a portfolio that is heavily weighted towards stocks and the stock market experiences a downturn, their portfolio may also decline in value. However, if the investor has a more diversified portfolio with a mix of stocks, bonds, and cash, the impact of a stock market downturn may be lessened.
- Risk Management: Asset allocation can help investors manage risk by balancing their portfolios in a way that is appropriate for their risk tolerance and investment goals. For example, an investor who is more risk-averse may allocate a larger portion of their portfolio to safer investments like bonds and cash, while an investor who is more aggressive may allocate a larger portion of their portfolio to riskier investments like stocks.
- Improved Returns: By properly allocating assets, investors can potentially improve the overall return of their portfolio. This is because different asset categories may perform differently in different market conditions. For example, stocks may perform well during times of economic growth, while bonds may perform well during times of economic downturn. By having a well-diversified portfolio, investors may be able to capture the potential returns of different asset categories and improve the overall return of their portfolio.
In summary, asset allocation is an important aspect of investing because it can help diversify a portfolio, manage risk, and potentially improve returns. It’s important for investors to regularly review their asset allocation and make adjustments as needed to ensure it aligns with their risk tolerance and investment goals.
We can help you with setting a proper asset-allocation and rebalancing it periodically. Want to know more? Book a free consultation session here.