What Is Asset Allocation And Why Is It Important?

When it comes to personal finance, one concept that often comes up is asset allocation. Asset allocation is the process of dividing your investments across different asset classes, such as stocks, bonds, and cash, in a way that they align with your financial goals and risk tolerance levels. The most common asset allocation includes equities, fixed income securities, and cash.

The importance of asset allocation cannot be overstated. Here are some reasons why it’s important.

Diversification: By spreading your investments across different asset classes, you can reduce your exposure to risks. If you only invest in one type of asset, such as stocks, you are vulnerable to market fluctuations in that particular asset class. However, by diversifying your portfolio, you can potentially reduce the impact of any one asset class on your overall portfolio.

Risk Management: Asset allocation can help you manage your risks by aligning your investments with your risk tolerance. For instance, if you have low risk tolerance, you may want to allocate a larger portion of your portfolio to bonds or cash, which tends to be less volatile than stocks. On the other hand, if you have a high risk tolerance, you may want to allocate more to stocks, which tends to have higher returns over the long term, but also comes with greater risk.

Goal Alignment: Asset allocation can help you align your investments with your financial goals. For instance, if you have a short-term goal, such as saving for a downpayment on a house, you may want to allocate more to cash or short-term bonds, which are less volatile and provide a more predictable return. On the other hand, if you have a long-term goal, such as saving for retirement, you may want to allocate more to stocks, which tend to have higher returns over the long term.

Rebalancing: Asset allocation also involves periodically rebalancing your portfolio to ensure that it stays aligned with your financial goals and risk tolerance. For example, if stocks have performed well and now make up a larger portion of your portfolio than you intended, you may want to sell some stocks and reinvest the proceeds in bonds or cash to bring your portfolio back into balance.

HOW ASSET ALLOCATION WORKS

Let’s suppose, you have a total investment portfolio of Rs 1 lakh and you want to allocate it across different asset classes. Here’s an example of how you might divide your portfolio:

Equities: 50 per cent (Rs 50,000)

Fixed Income Securities: 40 per cent (Rs 40,000)

Cash: 10 per cent (Rs 10,000)

Your equity allocation of 50 per cent is based on your higher risk tolerance and long-term financial goals, while your fixed income and cash allocations of 40 per cent and 10 per cent, respectively, are based on your desire for some stability and liquidity in your portfolio.

Now, let’s say after a year, your equity allocation has grown to 55 per cent of your portfolio, while your fixed income and cash allocations have shrunk to 35 per cent and 10 per cent, respectively, due to a strong performance of the stock market over the past year.

To bring your portfolio back into balance, you might consider selling some equities and using the proceeds to buy fixed income securities until your portfolio allocation is once again back to 50 per cent equities, 40 per cent fixed income securities, and 10 per cent cash. This process is known as rebalancing and it helps ensure that your portfolio stays aligned with your financial goals and risk tolerance over time.

It’s also important to note that asset allocation and rebalancing strategies will vary based on individual financial goals, risk tolerance, and investment horizon