Do you love to have junk food and want to have it every day? But practically, you cannot have it daily because it can never grab all the nutrients required for your body making it risky for your health. Hence, there should be a proper balance of nutrients for making a healthy lifestyle. Likewise, the same logic works for your investments. A single asset class could risk your overall portfolio so, there needs to be a proper balance between different asset classes to reduce risk in your investments. Therefore, one should maintain balance by choosing the right asset allocation strategy according to his investment objective and risk profile.
Before moving forward with asset allocation strategies, let's first understand asset allocation.
Asset allocation and its’ benefits:
Asset allocation is the process of dividing an investment portfolio among different asset classes such as equity, debt, real estate, commodities and cash. The purpose of asset allocation is to create a diversified portfolio that maximizes returns while minimizing risk. Asset allocation is recommended to be followed by investors because it can provide several benefits such as:
- Goal Setting: Asset allocation allows you to set clear investment goals, objectives and expectations. By determining your investment goals and the time horizon for achieving them, you can create an asset allocation strategy that aligns with your financial objectives.
- Balancing Risk & Returns: Asset allocation can help manage risk by spreading investments across different asset classes (diversification) with varying levels of risk and return potential. The idea is that by allocating assets among different asset classes that have low correlations with each other, it is possible to minimize portfolio risk while maximizing returns
- Decision-making: By maintaining an asset allocation strategy, investors can avoid making emotional decisions based on short-term market movements and help reduce the risks of wrong decision-making and benefit from market opportunities.
- Portfolio performance: Asset allocation has been found as the most important determinant of long-term portfolio performance as against investment /fund selection and market timing. It helps the investors achieve more consistent and better returns over the long run.
It would be interesting for investors to know to what extent does asset allocation determine the long-term performance of the portfolio? A few of the important studies done in the years 1986, 1992 and 2011 found that asset allocation accounted for approximately 93.6%, 91.5% and 95% of the variation in returns. As investors, we should not be concerned about the exact percentage. What is important for us is to understand the simple fact that following an asset allocation strategy religiously would determine how well our own wealth creation journey will take shape in life.
The main asset allocation strategies:
1. Strategic Asset Allocation: This approach involves setting a long-term target allocation to a mix of different asset classes and periodically rebalancing the portfolio to maintain that target allocation. The target allocation is based on the investor's goals, risk tolerance, and investment horizon. This strategy involves periodic rebalancing of the portfolio to maintain the target allocation and the allocation here does not change with the influence of the market. Say, for example, you have chosen 50:50 asset allocation, so you allocate Rs.50 in equity and Rs.50 in debt. A year later, the investment of Rs.100 grew to 114, Rs. 60 in equity, and 54 in debt. Now the portfolio will be rebalanced to the original portion of 50-50, i.e. Rs. 57 in equity and debt respectively.
2. Tactical Asset Allocation: Tactical asset allocation is a short-term approach to portfolio management that involves making adjustments to the portfolio based on changes in market conditions or economic outlook. The goal of this approach is to take advantage of short-term opportunities or mitigate potential risks. Unlike strategic asset allocation, tactical asset allocation does not have a fixed target allocation. Instead, the allocation to different asset classes is adjusted based on the investor's expectations for future market conditions. For example, if an investor expects interest rates to rise in the near future, they may reduce their allocation to debt and increase their allocation to equity. The idea is to make adjustments to the portfolio that are not necessarily based on the long-term outlook for the asset class, but rather on short-term fluctuations in market conditions.
3. Dynamic Asset Allocation: Dynamic asset allocation is a combination of strategic and tactical asset allocation. This approach involves setting a target allocation to different asset classes, but with the flexibility to make short-term adjustments based on market conditions. The adjustments are typically based on a set of rules/logic that takes into account market conditions, economic indicators, and other factors. A dynamic asset allocation strategy may increase or decrease the allocation to equity and debt from time to time as per some rules & logic. This strategy can be more responsive to market conditions than strategic asset allocation, but it can also be slightly more complex and difficult to understand and implement on our own.
Deciding upon an asset allocation strategy:
Each of the asset allocation strategies has its advantages and disadvantages, and the choice of strategy largely depends on the investor's risk profile and investment expectations. However, while determining any strategy, one should understand that the asset allocation is for the entire portfolio, including all your investments in traditional avenues like bank FDs, PPF, small savings, real estate & gold, i.e., anything which has been made for investment purposes. Thus, deciding and following an asset allocation just for your mutual fund portfolio is meaningless as it should be at the overall portfolio level. Investors who are following a financial plan are a step ahead as they have a clear target and time horizon in mind. Thus, the asset allocation can now be decided for each financial goal on the basis of the investment horizon, the required returns for the savings available and the risk you can take on it.
The Bottom Line
Determining an asset allocation strategy and the discipline to follow it should be the basic, core activity in your wealth management journey. This is not a one-time decision, but a continuous process that requires monitoring and periodic adjustments to ensure that the asset allocation strategy and the actual asset allocation remain aligned with the investor's objectives. It would be best if one approaches the experts who can help simplify all these things and help you manage your asset allocation in an effortless manner.