Asset Allocation – A Comprehensive Guide

Even if you are new to the process of investing, you may already be familiar with some of the most basic principles. 

How did you find out about them? 

Through every day, real-life experiences that are not related to the stock markets.

Have you ever noticed how hawkers frequently sell seemingly irrelevant items like sunglasses and umbrellas? 

That may look odd at first. After all, when will a person buy two very different items at the same time? Probably never, which is the very point I am trying to make through this article. 

When it rains, vendors on the street know that selling umbrellas is easier than selling sunglasses.

The opposite is true when it is sunny.

The vendor can reduce the risk of losing money by selling both items - in other words, by diversifying his product portfolio.

If you have understood this example, you've made an excellent first step toward understanding asset allocation and diversification.

Let us start with asset allocation.

What Is Asset Allocation?

Asset allocation is an investment approach that strives to balance the return and risk associated with different financial instruments.  It helps to balance risk and growth by distributing total investment across a wide range of asset classes. The risk and return categories of these asset classes differ. As a result, asset allocation helps an investor reduce the impact of risk on the portfolio, exposing them to each asset class that has a correlation with one another.

Summarizing: Asset allocation is the process of dividing an investment portfolio into various asset categories such as stocks, bonds, and cash. The process of identifying which asset mix to hold in your portfolio is highly subjective and personal. The asset allocation strategy that works best for you at any given point in your life will be largely determined by your time horizon and risk tolerance.

What Is The Importance Of Asset Allocation?

It is simple math.

An investor can protect against significant losses by including asset categories with investment returns that fluctuate in response to changing market conditions in a portfolio.

Historically, the returns on the three major asset classes have not fluctuated at the same rate. Market conditions that cause one asset category to perform well frequently cause another asset category to perform poorly. By investing in multiple asset classes, you reduce the risk of losing money and smooth out your portfolio's overall investment returns. If the investment return on one asset category falls, you'll be able to offset your losses in that asset category with higher investment returns in another asset category.

If you have 30 years until retirement, for example, you can afford to take more risk in exchange for higher returns by investing the majority of your portfolio in the equity asset class.

What Are The Various Types Of Asset Classes?

An asset class is a collection of various investment instruments with similar characteristics. When compared to other investments, those investments in an asset class tend to behave similarly. A portfolio's asset allocation is also aided by the composition of different asset classes.

The various asset classes or categories are as follows:

Equity

Equity, also known as stock, denotes ownership of a portion of a company. As a result, a stockholder is entitled to its assets and profits in proportion to the amount of stock they own. Over the last decade, equity has grown in popularity. Based on market capitalization, equity is further classified as large-cap, mid-cap, and small-cap. Furthermore, the equity is susceptible to stock market fluctuations. They perform well in a growing economy and poorly in a declining one.

Contingent Income

This is the most common and oldest type of investment. Corporate bonds, government bonds, government schemes, and so on are examples. These securities are issued for a set period of time and pay fixed interest payments to investors until maturity. Furthermore, they are more stable than equity because the performance of the bond is primarily determined by the issuer's quality.

Money and its Equivalents

They are also referred to as money market instruments. This asset class is best suited for investments with a short time horizon. Treasury bills, commercial papers, certificates of deposit, and other similar instruments are examples. The primary benefit of this asset class is that it is comprised of highly liquid instruments that can be redeemed within 90 days. They are regarded as a safe place to invest due to their high liquidity.

Property Management

This asset class comes in a variety of forms, and investors can profit from price appreciation. They concentrate on plots, commercial buildings, apartments, villas, and so on. You can also buy from real estate investment trusts in a dematerialized form, which can be time-consuming.

Gold

In India, gold is a popular investment. Many investors use gold in their portfolio as a hedge or a store of value. When the economy is weak or in trouble, this asset class performs well while the other asset classes perform poorly.

What Are The Factors Affecting Asset Allocation?

Time Horizon

The time horizon is the number of years or months that an investor will invest to achieve a specific goal. Different investment horizons necessitate varying levels of risk tolerance. For example, a long-term investment strategy may lead an investor to invest in a high-risk portfolio because market dynamics are uncertain and may change in the investor's favour. Short-term investors, on the other hand, may not want to invest in a riskier portfolio.

Tolerance for Risk

Risk tolerance refers to an investor's willingness or ability to lose a certain amount of their initial investment in exchange for potentially higher future returns. For example, investors with a high-risk tolerance are more likely to risk the majority of their investments in the hope of higher returns. Investors with low risk tolerance, on the other hand, reserve their portfolios for more secure assets that can protect their initial investment.

Investment Purpose

An investment objective is an individual's desire to achieve a specific level of return or to save for a specific reason or desire. Some investment goals may include children's education, travel, retirement, marriage, and so on. As a result, the investor takes risks and invests based on the investment objective.

Key Takeaways:

• Asset allocation is the distribution of wealth across investment vehicles such as debt, equity, mutual funds, real estate, and so on in order to achieve long-term financial objectives.
• The allocation of resources for investments is strongly influenced by individuals' tolerance for risk and potential returns.
• It is the preliminary stage in asset management that helps financial planners identify the type and duration of assets to invest in.
• Some prevalent asset allocation approaches include 100% bond allocation, 100% stock allocation, income allocation, balanced allocation, growth allocation, and so on.