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Financial Term of the Week- Asset Allocation

Investing is not science, i.e. it is not one truth for all. And that’s what makes it interesting and tricky, at the same time. The two major forces behind any investing decision are that of the risks involved and the returns expected. The risks pertain to the fear of losing the money that you have invested. Various types of asset classes can be equity, debt, gold, real estate and so on; and each of these has a varying degree of risk associated with it. Hence, investing in one asset class alone could be risky because if it underperforms, then you may end up losing your invested money.

How do you mitigate these risks? - By investing in various asset classes

How do you know how much to invest in which asset class? - By adopting the right asset allocation strategy

What is asset allocation?

Asset allocation is the process of allocating your money to different asset classes according to your financial goals, risk appetite and investment horizons. Hypothetically speaking, if your short-term goals are sorted, and you want to focus only on your long-term goals like retirement, then you may be alright investing more in equity mutual funds. Hence, after much research, you may decide on an asset allocation of 70:30 towards equity. The 30% of debt in your portfolio ensures that if there are any losses made by the remaining 70%, then the risks could be mitigated. Asset allocation decides how effectively you meet your financial goals. In fact, various studies say that more than 90% of your returns are based on asset allocation decisions. (Source: https://www.tandfonline.com/doi/abs/10.2469/faj.v56.n1.2327)

The concept of asset allocation also works because every asset class performs differently. This means that while one of them performs good, the other one may underperform and vice versa. Hence, staying invested in both may help you remain calm, knowing your portfolio is balanced. Unless under special circumstances, your asset allocation should ideally remain fixed. In the above example, if you find out that the asset allocation has become 60:40 due to underperformance of equity, you must correct the ratio back to 70:30. This process is called rebalancing.

Difference between asset allocation and diversification-

Quite often used interchangeably, the two concepts are different. While the former is about deciding on which assets to pick and how much to invest in them, the latter is about creating diversity within those asset classes. While the former may help you with a risk-return balance for the overall portfolio return, the latter could help you balance the risks within an asset class. Suppose you have an asset allocation of 60:40 towards debt. Now within the equity asset class too, there are a variety of options that you can choose from, depending on what you are willing to achieve. On the basis of how comfortable you are with the ups and downs of the market, you can distribute your investments amongst large-cap, mid-cap, equity-oriented hybrid funds or sectoral funds etc. This process is called diversification.

How to derive an asset allocation strategy?

Your age, your risk profile and your investment horizon are the most important factors to consider when deciding which asset class to invest in.

It is advisable to move most of your assets from equity to debt as you grow older. As a thumb rule, you can follow this rule - deduct your age from 100, and the remaining number is how much percentage of your assets you should invest in equity. So, if you are 25, you can allocate 75% of your asset to equity, and if you are 70, only 30% is considered safer.

In conclusion-

Asset allocation is not a one-time activity in your financial journey, but it needs you to keep a tab and keep a check every few years if your asset allocation is in line with your investment goals.



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