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.

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:

Time horizon

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.

Risk appetite

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.

Goals and Objectives

Your financial goals help you decide the assets you should invest in. For example, if you are saving for short-term goals, you can choose stable investments, while for long-term goals, you can take a bit more risk. You must align your investments to help you achieve your financial objectives.

Current Market Environment

The current market environment can affect your asset choices. Rising interest rates can make bonds less appealing, while stocks can be affected by political events or industry trends. Real-estate prices may also fluctuate based on economic conditions and mortgage rates. During market fluctuations, gold might be considered as a safe investment. Understanding how various asset classes are influenced by market changes can help you make better investment decisions.

Concerns about inflation

Inflation is the general rise in the prices of all goods and services. It is important to invest in assets which can help grow your savings while also beating inflation.

Asset Liquidity

When you are planning your asset allocation, you must include some assets which are readily accessible. This ensures you have funds available in case of any emergencies or unforeseen expenses. Cash in hand, savings accounts and stocks are some assets which offer high liquidity

Tax Efficiency

You can explore tax-efficient^# options to help you maximise your returns while saving on taxes.

Conclusion

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.

COMP/DOC/Jan/2023/311/2161