What is asset allocation and how to do it
Indian towns and markets are flooded with small shops and vendors. By the way, you will find people selling everything from samosas to sunglasses. Many of these entrepreneurs sell completely independent products, such as coffee and ice cream. This approach seems a little strange, but it turns out to work for them. When it’s cold, it’s easier to sell hot cups of coffee. When it’s warm, it’s easier to sell ice cream. By selling both, sellers reduce the risk of losing money on any given day. A similar activity in the world of finance is known as asset allocation.
Asset allocation means investing in different asset classes such as stocks, debt, gold, bank FDs, savings accounts, etc. Each of these asset classes has a different risk profile and therefore variable potential returns. Therefore, asset allocation is considered an essential part of creating an investment portfolio. However, this is not a one-time activity as it requires regular rebalancing.
By being invested in different asset classes, an investor prepares the portfolio to work in varied market conditions, thus eliminating any systematic risk. This not only helps keep your portfolio on track, but also helps control recency bias (a bias that gives recent winners a higher weight). At the same time, it is important to recognize that asset allocation is an investment risk management approach and does not guarantee against investment losses.
Determine the appropriate asset mix
There is no one-size-fits-all approach to asset allocation. It must be tailor-made because asset allocation is highly personalized in nature. There are two big factors that come into play when making the asset allocation decision.
Investment Horizon/Timeframe: A longer timeframe helps an investor take advantage of market volatility. An investor with a shorter timeframe should therefore consider investing in debt securities rather than equities.
Risk Tolerance: An investor with a higher risk tolerance is one who can withstand relatively higher market volatility while seeking potentially higher returns. On the other hand, an investor with a lower risk tolerance is one who is willing to give up potential return in favor of relatively less volatile investment options.
Everyone loves a winner. If an investment has performed extremely well, most investors prefer to stay invested in that outperforming asset class. But is this the best approach? Reserving profits for your winners most often seems counterintuitive. What is often overlooked is that the risk profile of a portfolio changes over time and this phenomenon is often referred to as “risk creep”.
Over time, the performance of different investments can change the risk profile of a portfolio and therefore it should be rebalanced from time to time. For example: Mrs. X is 50 years old. former and she is a moderate investor with a clear goal of maintaining a 50:50 asset allocation (Debt:Equities). She wants to invest Rs. 10 lacs. According to its asset allocation, Rs. 5 lacs each will be allocated to debt and equity respectively.
After a year, when looking at the portfolio, she realizes that her equity portfolio has grown to Rs.7 lacs while debt is at Rs. 5.30 lacs, distorting her original allocation by 50: 50 which is now at 43:57.
Here she has two options:
1. Reduce equity exposure by Rs. 85,000 and allocate it to debt OR
2. Invest another Rs.1.7 lacs in debt so that the original asset allocation is restored.
Another situation could be when his equity portfolio has fallen to Rs. 4 lacs while debt is at Rs. 5.3 lacs. Here she will have to add more equity by one of the ways mentioned above.
Indeed, rebalancing is the process of restoring a portfolio to its original risk profile. Over time, the investments made will produce varying returns, so the portfolio may bear little resemblance to the original allocation. Thus, rebalancing becomes very important. Periodic portfolio rebalancing based on your desired risk tolerance is good practice, regardless of market conditions. One approach is to set a specific time each year to schedule an appointment to review your portfolio and make adjustments if necessary.
To conclude, asset allocation lays the foundation for a strong portfolio, but periodic rebalancing works its magic by delivering optimal risk-adjusted returns over time.