As a child, I remember my parents insisting that I eat my vegetables before I could have dessert. I also remember the school textbook containing a food chart showing the constituents of a healthy and complete diet. It included fruits, carbohydrates, proteins, fats, etc. You might be wondering how this description of food has anything to do with investing. There is a lot about a plate of food that one could learn from by investing. The concept of a well-balanced investment portfolio closely mirrors that of a healthy diet. The key to building an optimal portfolio is to spread your investments across different asset classes.
Every investor wishes to maximize the return on his investment by taking a minimum of risk. This is where asset allocation comes in handy. Asset allocation is the distribution of your investments between different asset classes such as stocks, bonds and gold. A typical Indian thali is the right analogy for understanding asset allocation – there is something sweet, sour, spicy, salty and even bitter. The idea is to make the meal healthy in such a way that anyone who takes it is happy with the combination. Plus, they have the choice of adding more of something they like and cutting back on something they don’t.
The asset allocation decision is similar – it is personal and somewhat unique to investors and the goal they are investing towards. And, just as our eating habits change with age, the allocation that’s best for you changes at different times in your life, depending on how much time you need to invest and your ability to tolerate risk. Despite the many benefits of following asset allocation principles when investing; many investors do not give enough importance and attention to this method of portfolio construction, which often leads to suboptimal investment strategies.
To follow a proper asset allocation principle, one must understand asset classes and their role in a portfolio. For example, a stock or equity investment is an investment in a company (company) for proportionate ownership. This has its share of risks, but it also has advantages, especially in the case of a growing business, as the value of investments increases. The case of bonds or fixed income instruments is similar to lending, where the investor lends money to a company or government for a regular fixed interest payment over time. Similarly, gold is a commodity that comes in handy in times of economic downturn and times of inflation. The asset allocation decision – how much of your portfolio should be allocated to all assets is a crucial factor to consider as part of your investment strategy.
make a meal
When building a proper portfolio, include what you need to save money for – home, retirement, child’s education, or marriage are some common financial goals. Based on this first step, you need to determine the appropriate mix of assets. The decision is based on different returns and risks posed by each asset class, the investment risk you can bear, and which type of asset class suits which financial goal. For example, as a child, you could eat more sugar, but with age, excess sugar often has adverse consequences. Likewise, as you invest over time, you may need to increase or decrease exposure to certain asset classes. Ideally, you would need a higher allocation to equity to achieve long-term goals like retirement.
From now on, not all investors will have the means to manage the asset allocation themselves. While one can seek expert help, one could also consider multi-asset mutual funds and dynamic asset allocation funds. These are types of mutual funds where the principle of asset allocation runs deep and can be used by investors depending on their investment objective. It’s also a great way for investors to understand and concretely visualize the benefits of asset allocation. In a dynamic asset allocation scheme, two asset classes – equities and debt – are at work here. But in the case of a multi-asset scheme, the asset classes can be stocks, debts, gold and others.
To conclude, stick to asset allocation at all times and if you don’t know how to go about it, opt for an asset allocation system.