Imagine your investment portfolio to be your cricket team. You wouldn’t just pick all batsmen or all bowlers in your team, right? You would want a mix of batsmen, bowlers, and some all-rounders. Asset allocation is similar to building a cricket team. It’s about diversifying your money across different asset classes such as equity, debt, real estate, and gold to balance the risk irrespective of market ups and downs. So, ditch the one-dimensional approach and pick your investment team wisely with the help of asset allocation.
Factors Affecting Asset Allocation
Different investment goals demand different investing strategies. For example, saving for retirement which is 30 years away will have a different asset allocation strategy than saving up for your down payment which is just five years away. The former will have more equity, whereas the latter will have a mix of equity and debt. How long you want to stay invested also determines your asset allocation. A long-tenure investment should ideally have more equity as you have enough time to weather the market’s ups and downs. Alternatively, a short tenure should ideally have more fixed-income investments to ensure steady returns with low risk.
Your risk tolerance level also plays an important role in defining asset allocation. If you are okay with short-term market fluctuations and are willing to take additional risk for a high return, you have a very high tolerance for risk. However, if you can’t stomach the market ups and downs, you have a low tolerance for risk. Equity is an ideal asset class for high-risk tolerance, and debt is better for low-risk tolerance.
Popular asset allocation strategies
There are broadly four types of asset allocation strategies used by most investors in the market:
- Strategic asset allocation: After considering your goals and risk tolerance levels, you or your financial advisor can define the asset allocation. In this type of asset allocation, it is important to rebalance your portfolio as per the market movement periodically.
- Constant weight asset allocation: In this strategy, you can fix the percentage for each asset in your portfolio and constantly rebalance it to ensure the original target weights are met. For example, if you want to invest 50% in equity, 20% in bonds, 20% in real estate, and 10% in gold, then as markets fluctuate, you must constantly rebalance your portfolio to ensure these weights are maintained.
- Dynamic asset allocation: Dynamic asset allocation is a strategy where you constantly change your asset allocation based on market conditions. There is no fixed asset allocation in this strategy, and only investors or experts who have market knowledge should follow it.
- Age-based asset allocation: A popular asset allocation strategy is investing based on the age of the investor. According to this strategy, the younger you are, the more you can invest in high-risk investments. One of the popular age-based asset allocation strategies is the rule of 100. As per this rule, you subtract your age from 100 and invest that amount in equities. For example, if you are 30, then you must invest 70% (100-30) of your portfolio in equity and the rest in different low-risk asset classes.
To sum up, asset allocation is the foundation of your investment portfolio and provides a framework to manage your return and risk based on your goals, resources, investment tenure, and risk tolerance levels. Hence, you must be careful before deciding on the asset allocation for your investment portfolio.
Disclaimer: The Views are Personal and not a part of the Outlook Money Editorial Feature