Personal Investment: Why is Asset Allocation Important

An asset allocation strategy helps you build an appropriate investment portfolio after due consideration of your age, financial goals, both short- and long-term; the preferred time period of an investment; risks involved, and returns, etc. Though you cannot control events but predict them only to a certain extent.

However, asset allocation is not a guarantee for the highest return or protection against losses. But it surely is an essential tool, whereby losses arising from different asset classes can be minimised. Basically, this is achieved by selecting assets that are not related to each other – this is because all assets in one’s portfolio will not be impacted to similar extents by the same factors.

Strategic asset allocation: It is a long-term strategy with a goal, and normally is unchanged throughout. In other words, it involves sticking to long-term asset allocations. It is also known as optimal asset allocation. This is more of a passive strategy.

Tactical asset allocation: This strategy involves resorting to a periodic rebalancing of various assets to take advantage of emerging scenarios, market anomalies, or regulatory changes. This is more of an active strategy.

Basically, an asset allocation plan determines how the investment should be divided amongst various investment classes such as stocks, bonds, real estate, commodities and cash. Asset allocation plans are the single largest factor in determining the performance of a portfolio. It takes into consideration factors such as an investor’s age, income, dependents, investment period and their ability and willingness to take risks.

However, the adoption of a particular asset allocation strategy may differ between individuals. For example, you may want to invest Rs 60 out of Rs 100 in equities, whereas someone else may invest Rs 60 in debt and Rs 40 in equities. Then, for some, strategic asset allocation is the best strategy to achieve their financial goals; while for others, tactical asset allocation is a better idea as there is a possibility to exploit various emerging opportunities.

Active strategy: Suppose you invest Rs 100, divided as Rs 45 in equity, Rs 30 in debt and the balance of Rs 25 that you hold in cash. One day, you are informed that equity may not perform well in the coming year; and that markets may fall.

So what do you do? You rebalance your portfolio by reducing equity exposure to Rs 30 while increasing debt exposure to Rs 45.

In due course, when the market eventually witnesses a slide, you are able to minimise your losses. However, if the predicted crash did not occur, and stock markets were to rise, you would get a lower-than-expected return, as you rebalanced your portfolio earlier.

The above is an example of an active strategy, where you have acted on an emerging scenario, and rebalanced your assets portfolio. With such a strategy, you need to understand the economy, industry and the company quite well.

Going further, you as an investor need to follow a disciplined approach; and devote regular time and effort to tracking events along with your portfolio performance.

Asset allocation a necessity: It is quite difficult to determine in a year which particular asset class would be the best performing one. Investing in only one class of assets could prove to be risky. However, in the long term, it may overlook the market cycle; and provide returns.

It is important to note that asset allocation in different asset classes tend to offer returns that are not perfectly correlated. This means that diversification of assets in your portfolio reduces the overall risk in terms of the difference in return for a given level of returns that you expect. Therefore, it is prudent to have a mixture of asset classes, which is more likely to meet the expectations in terms of the amount of risk, and possible returns.

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