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Demystifying financial planning: What is Asset Allocation?

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“Instead of working for money, let your money work for you!”

During our schooling we have all been taught the proverb ‘Do not put all your eggs in one basket’. This analogy about risk applies to investment as well. We have all heard of farmers cultivating a mix of crops in their fields.

Ever wondered why they do it? What are the benefits?

Well, the benefits are plenty. When you cultivate a mix of crops in your farm, it helps improve your farm income from a variety of crops’ yields and protects you from the failure of a particular crop in unsuitable weather conditions. Overall, good effects result when the right combination of crops is grown together.

Asset allocation works on the same principle. Like planting of seeds of multiple crops in a farm, you have various types of assets that you can invest in. Your portfolio performance depends on the mix of asset classes to a large extent. This mix of asset classes known as asset allocation is one of the most important strategies you can devise to optimize the performance of your portfolio.

What are assets and the different asset classes?

An asset is anything that has value such as cash, real estate or even antique artifacts or art. In investing, similar assets are classified into asset classes. For the purpose of financial planning the following asset classes are considered:

    • Equity
    • Debt/Fixed Income
    • Real Estate
    • Gold
    • Cash

The various investment instruments can be broadly classified into these broad categories. The instruments falling in a particular asset class shall carry similar risk and return, are regulated by the same regulator and react the same way to market movements.

What is ‘Asset Allocation’?

Asset allocation is the method of splitting investments into more than one asset class. Practically, this means, some of your investible cash flow goes into, say, equity shares and mutual funds, some into fixed deposits and other fixed return products, and some into physical assets such as gold and real estate. There may be many rules for an efficient asset allocation.

To start with you would need the answers to the following questions:

  • How should you divide your capital among these asset classes?
  • What should be the percentage of each asset class?
  • How do you determine the asset mix that is right for you?

Asset allocation is a portfolio investment technique that targets balancing risk by determining the proportion of capital spread across various asset classes: equity, debt cash etc. Each asset class behaves differently over time and has different risk and return profiles. Similar to diversification, it is based on the theory that at any given time, the poor performance of an asset class will be offset by the good performance of another asset class within the investment portfolio.

Why Asset Allocation?

One of the most important questions which we face in our financial life is how much we need to save and invest? The amount is precious as it comes from you sacrificing on today’s luxuries for tomorrow’s comfort. Therefore, the money you decide to save is too important to be invested without a strategy. It is for this reason, asset allocation becomes extremely important. Simply put, it divides your hard earned investment into various asset classes that give you potential to earn higher returns while lowering the risk by diversification. The following factors play an important role in determining an asset allocation strategy that works for you. It is different for each individual investor.

Your asset allocation strategy will largely depend on:

  • Risk tolerance – Your willingness to brave ups and downs of the market for more potential returns in long term. You may be happy with 25% returns but are you also willing to take a loss of 25% on your investments? You may be willing to take risk in a bull market, but true risk tolerance may be tested in a bear market.
  • Time horizon – How long can you stay invested without withdrawing or selling your investments? Also how long do you expect or want corpus to last?
  • Financial objectives – What are your financial goals? Do you want to invest to improve your current lifestyle? Or you want to build a corpus for your children’s education, maintain the current lifestyle post retirement or buy a new house?
  • Liquidity needs – How much do you need each month to maintain your current standard of living? What are your present assets? Do you expect to spend a lot of money in the near future on marriage, education, or a medical requirement?

It is important to determine an asset allocation strategy considering the following two factors:

  • Expanding Options – The array of alternate investment options are growing day by the day for investors. While they certainly make the portfolio construction process more complicated, they also provide new corridors for increasing potential returns while managing risk. It becomes important to, therefore, understand all options and then take an informed decision on which asset classes you want to choose and how much you want to allocate to each of them.
  • Risk Management – Your asset allocation strategy must make optimum use of diversification. This not only enables you to manage volatility by reducing risk and increasing potential returns, but also helps you ride the ups and downs of the market with more confidence.

The asset allocation strategies can be broadly be classified into three categories as far as investments in debt and equity asset classes are concerned.

  • Conservative – More exposure to debt
  • Moderate – balance between debt and equity
  • Aggressive – more exposure to equity

Determining the right allocation strategy will help you successfully meet your long-term or short-term financial goals. For example, for long term goals, an aggressive asset allocation strategy with more exposure to equity mutual funds may be preferred as it helps generate higher potential returns, while reducing risk and beating inflation. It may be better to invest safer options or follow a conservative asset allocation strategy for short-term goals. Determining the right strategy will help you strike this balance. Coupled with financial discipline, it will ensure that you get closer each day towards achieving financial freedom.

Happy Investing!

This article has been contributed by CA Dhruv Rawani, Founder – Vitta Advisors. For more details, contact him on +91-9773164338.

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