Imagine you are in a restaurant ordering a full thali. You have a diverse menu containing chapattis, 2-3 types of veggies, daal, rice, salad, pickle, 2 variety of sweets, etc. Note that each item would be served in the relevant proportion. For instance, the pickle or the sweet do not occupy a major portion of the meal like the grains & pulses and will be served just in the right measure. Eating more of pickle or the sweet could be harmful to your health.
Asset allocation is similar to the menu of a full thali. It involves diversification and distribution of investment assets in the proportion suitable to your personal financial life. While it is one of the primary tools in reducing investment risk, asset allocation is an often-ignored element of investing. This is because most investors do not view their portfolio in totality. They find the word itself to be some sort of a complicated jargon.
It is simple to understand though. All asset categories (broadly classified as equity, debt, real estate, gold) behave in a different fashion under different economic situations. For instance, in a scenario of high inflation and rising interest rates, fixed deposit returns would be high. On the other hand, rising interest rates is bad news for equity markets and they generally suffer as expensive credit is speculated to slow down investment growth.
It is thus prudent to distribute the investments across different asset classes to minimise downside risk. The popular saying, ‘Do not put all your eggs in one basket’ explains the concept of asset allocation well. Here are few things you as an investor should bear in mind while adapting the strategy of asset allocation in investing:
Age: It is generally understood that lower the age of an individual, higher is the risk-taking ability and vice versa. So, a young person can take greater exposure to volatile assets like equity shares/mutual funds in his portfolio compared to an older person. This is because he has more time to earn money. However, age as a factor cannot be considered as the sole criteria. The general thumb rule of 100 minus age to determine the equity allocation in a portfolio is not always applicable. E.g., the equity allocation of 70 (100-30) and the balance in debt cannot be applied universally to all 30 year olds. It is possible that an investor may decide to retire early. In that case, his portfolio will be heavily tilted towards equity as his retirement nears. Further, a big exposure even post retirement is not healthy as it puts his retirement savings at risk of erosion. Another scenario where this general thumb rule is unlikely to work is if an investor is self-employed. The erratic nature of his business income would tone down his risk-taking ability to take heavy exposure to equities even if he is young. Thus, age of an individual needs to be considered in conjunction with an individual’s personal and financial situation while determining the asset allocation.
Time horizon: Money is required for different financial goals at different life stages. So, the risk-taking ability varies depending upon the investment horizon. Based on the duration for which the money needs to be kept invested, an investor can decide his asset allocation. For instance, home renovation in 3 years can be viewed as a short-term goal while a child’s higher education which is 10-15 years away can be considered as a long-term goal. For short- term goals, usually fixed income options should be preferred. For long-term goals where investors can afford to take risk, equities can be given a big exposure in the total portfolio.
Financial Goals: Asset allocation plays an important role while investing in sync with financial goals. When investing for a long-term goal like child’s higher education, 100 per cent equity funding should not be preferred even if it is for the longer time frame. It is wise to apportion a small portion of the funds to fixed income options. Similarly, asset allocation needs to change at different life stages. For e.g., it is prudent to move investment from risky to safer options like interest bearing options in advance especially when goals are nearing an end. On the other hand, while an investor post retirement prefers fixed income options for regular & safe income, a small exposure to equities is essential to provide growth to the retirement corpus. Read(why retirees should invest in equities. )
Personal situation: A bread earner having limited income and many financial dependants is unlikely to take higher risk and may prefer safe interest earning options. The nature of occupation can also play a role in determining the asset allocation. A salaried person with regular stream of income will have a different asset allocation compared to a self-employed individual with erratic income.
Personality trait: Risk taking ability also depends upon individual personality traits. A conservative investor may not take equity exposure at all because he finds it too risky. On the other hand, an aggressive investor is likely to carry greater risk of capital loss in exchange for higher returns. Every individual has an inherent risk tolerance and he needs to recognise the same through risk profiling. One can consult an expert financial advisor to understand ones true risk profile and accordingly make asset allocation decisions.
To conclude, asset allocation is highly crucial for successful investing. It helps you to align your investments with your true risk tolerance depending upon your individual situation. Also, asset allocation needs to be reviewed from time to time as an investors goals and risk tolerance change from time to time.