Building a Strong Portfolio: The Basics of Asset Allocation
The Basics of Asset Allocation
Key Takeaways
- An asset is something you own and that has value.
- Asset classes include stocks, bonds, fixed deposits, gold, cash and cash equivalents, real and tangible assets.
- Asset allocation refers to dividing your investments among different asset classes, such as stocks, bonds, and cash.
- Asset allocation is crucial for diversifying your investments, managing risk, and maximising returns in your portfolio.
- You can choose an asset allocation strategy based on your age, risk tolerance, and goals.
When you plan your meal, you don’t just eat one thing, right? Imagine you’re sitting down for a meal and all you have is a plate of French fries. Sure, they may be tasty, but they won’t provide you with all the essential nutrients your body needs. That’s why a wholesome meal includes a variety of food groups like fruits, vegetables, grains, proteins, and dairy.
Similarly, when it comes to investing, asset allocation is like creating a well-balanced financial meal. Instead of putting all your money into one type of investment, you diversify your portfolio across different asset classes.
Before getting into the nitty gritty of asset allocation, let’s first get a hang of “What is an asset?”
In simple words, an asset is something that you own and that has value. It can be a physical object like a house or a car, or it can be something intangible like money in a bank account or investments in stocks or bonds.
What are Asset Classes?
Asset classes refer to different categories or groups that investments can fall into based on their characteristics and behaviour in the financial market. It’s like sorting things into different groups based on how they work and what they do.
Here are the popular asset classes in India:
Stocks: Stocks or equities are considered one of the most volatile asset categories – high risk & high return. Over time, stocks are known to offer the highest return and will generally outpace inflation but also come with the most risk. Stocks and equity-related instruments take investors on a thrilling ride influenced by social, economic, political, and macroeconomic factors. They’re known to help with long-term wealth creation.
Fixed Income: Fixed income instruments like bonds are safer than stocks, but also come with lower returns. This asset class offers stability and predictability. Government securities, corporate bonds, bank fixed deposits, and public provident funds (PPF) are some of the popular fixed-income investment options available in India. Think of this as a low-risk low return category.
Gold: In a world of uncertainty, gold shines as an asset class that transcends time. Acting as a diversifier, gold provides a hedge against inflation, weak economy, and uncertainty (e.g. due to war), offering stability and preserving value.
Cash and Cash Equivalents: We generally don’t see cash as an investment, but cash equivalents like savings accounts, money market funds (commonly known as liquid funds), and treasury bills, are all avenues where investors can park their funds. They’re all liquid assets, often considered the safest place to invest but also offer low returns. One must always have some part of their portfolio into liquid assets for emergencies and uncertainties.
How Does Asset Allocation Work?
Asset allocation strategy spreads your investments across different assets – thereby helping you mitigate your loss and maximising your growth potential. Let us understand how. Each asset class behaves differently and comes with different risk and return characteristics. Markets often work in cycles, and different assets may go up or down at different times. For example, when stock markets are down, gold prices may be rising and vice-versa (helping to offset losses).
By allocating your money across these different assets, you create a balanced portfolio designed to weather uncertainties and volatility associated with each asset class.
Why is Asset Allocation so Important?
Building a Strong Financial Foundation
Just like constructing a sturdy building requires a strong foundation, your investments need a solid base too. Asset allocation serves as the foundation for your portfolio, ensuring stability and balance. It involves spreading your money across different types of investments, such as stocks, bonds, and cash.
Diversification-A Safety Net
Diversification is like having a safety net for your investments. When you diversify, you spread your money across different types of investments, such as stocks, bonds, and cash. The idea is that if one investment doesn’t perform well, the others can help cushion the impact and potentially generate positive returns.
Customising for Success
Asset allocation is not a one-size-fits-all approach. Your age, risk tolerance, and investment goals play a crucial role in determining your optimal allocation. Younger individuals with a longer investment horizon can afford to take more risks, while those nearing retirement may prefer a more conservative allocation.
Regular Reviews and Rebalancing
Asset allocation is not a set-it-and-forget-it strategy. As time goes by, your investments may shift and drift from your desired allocation. Regularly reviewing and rebalancing your portfolio ensures that it stays aligned with your goals. Think of it as fine-tuning your investment strategy to stay on track.
Create Your Asset Allocation Strategy
Similar to cooking a tasty meal, creating an asset allocation plan that suits your preferences is simple. Similar to how you would think about your preferences and nutritional requirements, developing an allocation strategy entails taking age, risk appetite, goals, and time horizon into account.
A man in his fifties looking for stability and progress would presumably choose assets with a higher chance of success. A person in his twenties, on the other hand, will be more likely to embrace risk and invest in interesting stocks.
Furthermore, if you are a risk-averse person, you might not want to risk your money and end up choosing safer investment options.
When developing an asset allocation strategy, a number of additional factors, including your financial performance and time horizon, are taken into consideration.
Is there any Rule of Thumb for Asset Allocation?
For many years, a generally used rule of thumb has helped to simplify asset allocation. This rule states that people should own a percentage of stocks equal to 100 minus their age. Therefore, 40% of the portfolio for a typical 60-year-old should consist of stocks. High-grade bonds, public debt, and other generally safe assets would make up 60% of their portfolio.
Summing Up
Asset allocation is the cornerstone of a successful investment strategy. By spreading your investments across different asset classes, you create a balanced and resilient portfolio. Diversification protects you from the volatility of the market, reducing the risk of losing everything.
Remember to customise your allocation based on your age, risk tolerance, and goals. Regularly review and rebalance your portfolio to stay on track. Consider strategies like strategic, tactical, or dynamic allocation, as well as age-based or target-date funds. By embracing asset allocation, you can build a solid foundation for your financial future and maximise your chances of long-term success.
