Asset allocation is a very important part of creating and balancing your investment portfolio. This term is widely used by the financial expert. It plays an important role in maximising the portfolio’s overall return. The most famous phrase ‘Never put all your eggs in one basket’ is used to simplify the term asset allocation.
What is Asset Allocation?
Asset allocation is the process of deciding how to divide your investment across several asset categories. Stocks, bonds, Mutual funds, other debt instruments, and cash or cash alternatives are the most common components of an asset allocation strategy. Asset allocation means diversifying your portfolio. The construction of the portfolio involves allocating money to various asset classes. This process is called asset allocation.
In simple words invest your money in different types of an investment product to minimise your risk and maximise the returns. The asset class can be cash, equity, debt, real estate and gold. Asset Allocation depends upon your age, risk-taking ability and time horizon for the particular goal. Asset Allocation also provides for a direction to the future income and cash flows of the investor in terms of where he should invest to achieve his/her financial goal.
It is very difficult to determine which particular asset class would be the best performing one in a given year. Investing in only one class of asset in the expectation that it would outperform all the other investment categories could prove to be risky. If a portfolio is diversified, then irrespective of which asset class is out performing the investor will have some exposure to each one of it.
The better performing asset classes in the portfolio will help protect the returns of the portfolio from the poor returns in other asset classes. Asset Allocation reduces overall risk in terms of the variability of returns for a given level of expected return. Therefore, having a mixture of asset classes is more likely to meet the investor’s expectations in terms of amount of risk and possible returns.
Asset allocation linked to financial goal
When a need can be expressed in terms of the sum of money required and the time frame in which it would be needed, we call it a financial goal. Asset allocation linked to financial goals is the most appropriate form of asset allocation strategy. The investment horizon is a function of the investor’s financial goals, depending on when the money would be required to fund some of life's special events.
While implementing as asset allocation linked to your financial goals, you should consider following steps
• Assessment of your risk profile based on ability and willingness to take risk.
• Assessment of the needs. How much money will be required and when? You also need to assess the available resources and match the same with the need.
• Selection of the asset classes based on risk taking ability and time frame.
Diversify your portfolio with different asset classes
A group of investments that exhibit similar risk and return characteristics, and respond in a similar fashion to economic and market events are grouped together as an asset class. The risk and return features of each asset class are distinctive. Therefore, the performance of each asset class may vary from time to time depending upon the prevalent economic factors.
1. Equity asset class: Equity as an asset class represents a growth oriented asset. The major source of income to the investor is growth in value of the investment over time.
While investing in equity you should consider building your portfolio under a Core and Satellite approach. In this approach, according to the 20 to 40 age group, 70% of equity investment should be invested in the good quality Nifty/Large-cap fund and Flexi-cap fund. And those in the mid-40s should allocate 80% in above funds. The large-cap can generate 10 to 12% returns for SIP investments.
And rest 30% into the mid fund for 20 to 40 years age group and those in their mid-40s should have 20% exposure. Mid caps have potential in generating 12 to 14% returns. They can provide a kick for your portfolio returns. This arrangement will help to generate a higher return by minimising the risk of a downward fall.
If you don't have enough fundamental and technical knowledge of direct equity stock please refrain from investing in direct equity blindly. Instead, take the Mutual fund route.
2. Debt asset class: Debt as an asset class represents an income oriented asset. Major source of income from debt instruments is regular income.
Your 30% of the investible surplus should be invested in debt products for younger people and in mid-40s people should have 40% corpus in Debt products like PPF, VPF, SSY, good quality debt funds , gilt funds and NPS if you find it suitable.
PPF, NPS, and EPF are the best debt vehicle for long term wealth creation. For short term goals, invest in Debt mutual funds, FD and RDs.
Risk and return characteristics of Bond are relatively lower than equity and hence suitable for an investor seeking regular income flows with minimum risk.
3. Real estate: Real estate involves investment in land or building (commercial as well as residential) or Real Estate Investment Trust (REIT). Real estate prices are increasing day by day. But it suffers from liquidity risk and is impacted by economic cycles.
Residential properties prices are stagnant since the last couple of years but Investment in commercial properties and land can be fruitful in the long run. There is regular income through rent and capital appreciation in the Commercial property market. Real estate is an Income-Oriented asset as well as Growth Oriented asset class.
4. Gold: Physical gold is preferred by Indian families as a secure and stable investment but is it somehow illiquid. Gold can be considered as the hedge against inflation. It also provides an option of asset class for diversification within a portfolio of assets, being directly or indirectly correlated with other asset classes.
Gold and commodities are susceptible to changes in demand and supply.
5 to 10 % of exposure in gold is good enough. You can invest in gold through Gold ETFs but Gold Sovereign bonds are preferable.
5. Cash and cash alternatives: Cash is generally held for meeting day to day and emergency requirements. Cash holds negligible value in terms of returns and hence there is minimal risk. One should have a minimum amount in cash.
The existence of asset classes with different risk and return features provide investor’s choice of selecting asset classes that meet their requirement for return and risk tolerance. Investors seeking higher return and willing to take the higher risk will look at equity, while investors seeking lower income and lower risk will consider debt investments.
Financial experts like me, believe that determining your asset allocation is the most important decision that you’ll make with respect to your investments - that it’s even more important than the individual investments you buy. Proper asset allocation and discipline to stick to that plan is very important to create long term wealth.
Remember these two important things for long term wealth creation
• Invest regularly as per your asset allocation
• Stay invested for long
Preeti Zende is a SEBI registered Investment Adviser and Fee only financial Planner. She is Founder and owner of Apana Dhan Financial Services, Associate of Insurance Institute of India.