July 30, 2016
We make investments with the aim of maximising returns and minimising risks. It is important to have an investment strategy that helps us reach our financial goals by balancing risks and rewards. Asset allocation comes to play here. It is a strategy to build the investment portfolio such that the risks are rewards are balanced optimally.
Image courtesy of Sira Anamwong at FreeDigitalPhotos.net
There are different assets that one can invest in like equity, bonds, cash, gold, real estate etc. Each of these assets have different risk levels and different returns across different time periods. Asset allocation ensures that one does not put all his eggs in one basket but diversify money across different assets so that the investments are protected if things go wrong in one asset class, sector etc.
If your investments are diversified, you can withstand economic ups and downs. If your asset allocation strategy is optimal, it may even increase the returns potential.
Asset allocation aims to protect your investments from extreme ups and downs. The right asset allocation depends on various factors – risk, age, financial goals, income and expenditure. There are different ways of setting up an allocation strategy –
1) Asset Allocation based on Risk Capacity and Risk Tolerance of the Individual
All investments carry an element of risk. Each person is different when it comes to his or her capacity and tolerance level for risk.
Risk capacity – The level of risk that you can take based on your income and wealth.
Risk tolerance – The psychological impact on you of taking such risk. You should first identify your risk capacity and risk tolerance levels. Based on them, you should devise an asset allocation strategy.
Here is some guidance on how you should invest depending on your risk profile –
2) Asset Allocation based on Age of the Individual
Age is an important factor in determining asset allocation. Traditionally, it is believed that the equity portion of your portfolio should be equal to 100 minus your age. So if you are 30 years old, you should have 70% of your portfolio in equity (100-30). But nowadays financial experts concur that aggressive investors can consider 110 or 120 instead of 100. When you are younger, your stock investments have a longer time to ride over ups and downs of the market. When you are older, you might want stability in your investments and might want to invest in relatively less risky assets. Of course, if you are not young but have an appetite for higher risk in your portfolio or feel the need to invest in assets giving higher returns to meet your retirement goals and to beat inflation, you can have a higher percentage of your portfolio in stocks.
3) Asset Allocation based on when the money is required
Asset allocation determines how much of your money is invested in different assets. Each asset class is different from another in terms of liquidity and giving potential returns in the short-term and long-term time frames.
If you need the invested money back in a short-term of about 3 months to 6 months, the money should be invested in liquid mutual funds or a savings bank account or a short-term FD. It should be easy to redeem the money.
If you need money in the medium-term (3 years to 5 years), you should invest in debt instruments or balanced mutual fund schemes.
If you need money for long term financial goals, invest in equity mutual funds and the stock market as equity generally offers the best returns in the long run.
Image courtesy of [name of the image creator] at FreeDigitalPhotos.net
What are the best practices of asset allocation?
Asset allocation is important for financial success. Invest in different asset classes depending on age, risk profile, asset potential and your current financial situation. Review your investment portfolio regularly to ensure you are on the right track.