There are certain terms that are very frequently used in the personal finance space. One among them is “Asset Allocation” that is heavily thrown around. But what exactly is it?
The technical definition of asset allocation is “Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor's risk tolerance, goals and investment time frame. The focus is on the characteristics of the overall portfolio. “. Too hard to understand right? Let us simplify it for you.
Asset allocation, in simple words, means not keeping all your eggs in one basket. Let us take an example. Suppose you have 10 lakh rupees with you and you have to distribute it among different assets like gold, real estate, equity through stocks and mutual funds, debt through fixed income products and bonds, PPF, EPF and cash. The manner in which you will distribute these 10 lakhs among all the assets is known as asset allocation. You can distribute it as per your liking or follow various techniques outlined by financial experts.
Now that we have understood what asset allocation is, how should we ensure that our assets are allocated in the best possible manner? Let me break the news to you, there is no best asset allocation formula. Before thinking about asset allocation, you must ensure that the basics are covered. Try to answer the following questions to begin with -
- Do I have people in my family who are dependent on me? If yes, do I have adequate term insurance to cover the risk of untimely death?
- Do I have health insurance which is not dependent on my employer to meet all healthcare needs?
- Is there enough cash set aside as emergency funds to meet emergencies such as a job loss or prolonged illness?
Once you have addressed the above questions and ensured that things are in order, you should start thinking about your financial goals. For all short-term goals, do not park your money in any long term assets such as equity, gold, or real estate. This means that all short-term needs should be met through fixed income instruments only.
Asset allocation becomes important for long term goals like retirement or even for managing a large corpus where the primary objective is to increase the wealth. In such cases, you must first assess your risk appetite. While theoretically it may look like that your risk-taking ability is high, it is likely that you will not be able to stomach the volatility of equity markets.
It is recommended that you spend a decent amount of time figuring your risk appetite by considering your experience with each asset class, the tenure of your investments, your required rates of return on the overall portfolio to determine how much you should be allocating to each asset class. Apart from figuring out the required allocation to each asset class, you must also ensure that the desired investment in each asset class ensures that you achieve the best post tax return that the asset class can provide through various options available.
For example, if you have to allocate to gold, sovereign gold bonds should be your choice of instrument as they not only pay 2.5% interest annually in cash, but there is also no capital gains tax if you hold the bonds till maturity. Capital gains tax exemption is not available in any other modes of investment in gold. It is prudent to consult an advisor who is well versed with such nitty gritties. Asset Allocation is also a factor of future market outlook, if as an investor you think equity is overvalued you can keep the allocation low (relatively) towards equity.
Asset allocation of a salaried middle-class person will be totally different from a wealthy businessman. A salaried employee will have a significant portion of his savings in EPF, NPS and Real Estate whereas businessmen have a major allocation towards their own business equity.
After deciding the asset allocation, one needs to take a call on sub-asset classes as well. For example, if someone has decided to keep equity at 70%, it also needs to be decided how much to be allocated towards direct stocks (and proportion as well) & mutual funds (different market cap and styles).
Three major points to consider asset allocation - Risk Appetite, time horizon of investments & future market expectations.
Nishant Batra CWM® is Chief Goal Planner of Holistic Prime Wealth.
Disclaimer: The views expressed in this article are of the author, not MintGenie.