In our previous articles, we elaborated the benefits of diversification as well as the perils of over diversification in a portfolio. Essentially, asset allocation is an organized and effective method of diversification. It is a strategy of dividing the investment portfolio across various asset classes and within an asset class. The basic purpose of asset allocation is to gain value – either in terms of capital appreciation or stable inflow of funds in a timely manner, with attributing the lowest possible level of risk for achieving the financial goals.
- Asset Allocation as per Risk Profile
The first and foremost step in the asset allocation strategy is the determination of an individual’s risk profile. It not only helps prepare the individual with realistic market scenarios but also helps the advisor understand the individual’s risk taking ability. An aggressive investor can be recommended a higher allocation to equities but a conservative investor will be recommended low risk investment products.
- Allocation as per Financial Goals
Investors may use different asset allocation strategy for different objectives. Someone saving to go on a vacation in the short term (a year or less) might invest in liquid mutual funds or savings account with a bank in a conservative approach. The same individual saving for retirement in the long term (a decade or more away) will invest heavily in the equity markets to earn adequate returns.Illustration: For better understanding & showing how the portfolio’s asset allocation will differ as per the time period we have to achieve our goals, below is an example where we have divided goals in different time horizon.
- Selection of Investment Option
After ascertaining the asset class, an individual needs to ascertain the mode of investment. It might be a choice between Direct Equities, Portfolio Management Schemes or Mutual Funds. This can be further diversified into a mix of large cap, mid cap and small cap asset allocation. Selection of the investment option varies depending upon an individual’s understanding of the product, expected return, risk appetite & investment horizon.
Note: The above chart depicts only one example for explanatory purposes.
Conclusion
Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, current market scenario, risk tolerance and investment horizon. There are no “good” or “bad” allocations— an investor needs to find the one that’s aligned to the financial goals.
