What is Asset Allocation?
Asset allocation refers to distributing or allocating your money across multiple asset classes, such as equity, fixed income, debt, cash, and others. The primary purpose of asset allocation is to reduce the risk associated with your investment. It is possible that all your assets may not provide you with similar returns. Some assets that provide market-linked returns may get affected by market volatility. Hence, by investing in multiple asset classes, you can reduce risk, lower the probability of losses and improve the possibility of earning better returns.
Asset Allocation in investment
The most important determinant of an investor’s long-term investment results is the composition of assets or asset mix in the investor’s portfolio. While factors such as security and manager selection do matter, statistically speaking, their impact keeps falling as the investment horizon gets longer, leaving asset allocation as the dominant factor driving investment results.
Thus, in any financial planning process, arriving at an appropriate asset allocation is the most critical decision variable. In the asset mix, there are likely to be assets which have higher rewards and higher risks such as equities and assets, which have lower rewards and lower risks such as government bonds. In other words, over the long term, policyholders cannot expect equity type of returns by participating in pure debt funds (low risk-low reward) and vice versa.
An investor should balance risk tolerance* to maximise future value over the investment horizon. Risk tolerance* is the ability to tolerate either a more likely temporary or a less likely permanent fall in the value of the investment. Investors who cannot tolerate a fall in the value of investment from time to time (i.e. volatility in returns) should restrict their exposure to the riskier asset class of equities. Likewise, investors who have substantial working life ahead and who have limited financial liabilities in the medium term should take exposure to a high level of equities in their overall asset allocation.
ICICI Prudential Life Insurance Company offers a wide suite of funds which range from equity funds to pure debt funds and also balanced funds (a blend of both debt and equity) available for policyholders with varied risk appetites and investment horizons. Please refer to the individual policy-related document for the availability of the funds as per your choice.
We offer protection as well as savings-related life insurance/pension plans as per the needs of policyholders to help save for their goals/retirement planning and for the financial security of their families.
Importance of Asset Allocation
It is difficult to predict how the market will perform in the future and how it will affect your investments. When you invest in multiple asset classes, such as fixed income, debt, and more, your risk is spread across these various assets and hence, factors such as market volatility will have a lesser impact. This ensures that if one asset underperforms, you get returns from another asset which performs better. This way, the overall risk and returns are balanced.
Age-Based Asset Allocation
Asset allocation can be decided on the basis of your age. You may use the rule of 100 to determine the asset allocation for your investment portfolio. The rule requires you to subtract your age from 100 to arrive at the percentage of your portfolio investment in equity.
For example, if you are 40 years old, you can invest (100 – 40) = 60% of your money in equity. The remaining 40% can be invested in fixed income (debt) and cash.
With age, your risk appetite drops, which is why your investment in equity may also need to be reduced.
For instance, continuing with the same example above, ten years from now, when you turn 50, your allocation can be (100 – 50) = 50% in equity. The remaining 50% can be invested in fixed income and cash.
Factors that can affect asset allocation
Below are some key factors that can affect your asset allocation:
Some plans such as ULIPs provide high returns over the long term. However, they may have a lock-in period and hence they are suitable for investments with a long time horizon. If you have a shorter time horizon for investment, for goals such as buying a car, travelling, and more, you may consider investing in an asset class that allows you to withdraw money at your convenience.
All investments carry risk. Some asset classes offer lower risk than others. The lower the risk the higher is the probability that your investment is safe, and vice versa. Risk appetite refers to your capacity towards taking a risk. If you have a higher risk appetite, you may consider investing in asset classes such as equity or market-linked funds. If you have a lower risk appetite, you may consider investing in fixed-income instruments or debt funds.
The right allocation of funds in the right combination of assets can help you maximise your returns and limit risk. It is also essential to understand that asset allocation may differ for each investor. Further, your asset allocation may require changes as you age or as your financial goals change.
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* Risk tolerance is a measure of the level of risk you can take on your investment.
^ Please refer to the individual policy-related documents for the availability of the funds as per your choice.