Using the asset allocation strategy for rebalancing your portfolio will help restore the desired asset mix for your portfolio.
Asset classes often have a negative correlation in terms of their returns.
Asset allocation is the process of striking a balance between your risk and rewards by diversifying your investments across various asset classes, such as equity, debt, cash equivalents, gold, etc. according to your risk appetite, financial goals, and investment horizon. It plays a crucial role in one’s financial planning and has a greater impact on your portfolio returns over the long term than security selection and market timing. However, most investors miss out on understanding their importance and choose mutual funds based on their current performance.
Here, I will list 4 reasons why adopting asset allocation strategy is crucial:
Each asset class comes with distinctive features. Some might score high on capital protection and income certainty while others score high on returns. For example, equities can be highly volatile in the short term while generating higher returns as compared to other asset classes over the long term. Fixed income securities, on the other hand, can offer higher capital protection and income certainty features while under-performing equity mutual funds over the long term. Hence, in a portfolio with a diversified exposure to both equities and debt instruments, the equity component helps in yielding higher returns while debt constituents ensure stable returns during volatile market conditions.
Reduces market risk
Asset classes often have a negative correlation in terms of their returns. Market conditions may result in an asset class to register higher gains while reducing the value of another asset class. In such cases, diversifying investments across asset classes having negative correlation can counterbalance the losses arising from correcting asset classes. For example, fixed income instruments and equities show negative correlation. An economic decline or a fall in the corporate profits might weaken the equity markets. As a reaction, the central bank may try and revive the economy by reducing the policy rates to lower the borrowing costs, resulting in an appreciation of bond prices. Hence, having both equities and debt in your portfolio will allow you to get your losses from your equity portfolio counter-balanced by capital appreciation of your debt investments.
Similarly, gold and equities are also both inversely correlated. When equity investments witness a fall due to global or geopolitical uncertainties, the value of your gold investments will appreciate to offset the losses in your equity portfolio.
Addresses liquidity needs
Liquidity is a crucial factor that one should consider while making investments. It refers to the ease with which one can convert their investment into cash. Asset allocation strategy helps you maintain adequate liquidity by investing a part of your surplus in relatively safer asset classes to mitigate short term goals or financial emergencies. For example, if you park your contingency fund in equities, any financial emergency occurring during bearing markets may force you to sell those holdings at a loss. You should instead park your funds in short term debt funds such as ultra-short duration and short duration debt funds to ensure liquidity and capital protection.
Helps in rebalancing portfolio according to financial goals and asset mix
Asset allocation strategy also helps you in rebalancing your portfolio according to the time horizon of your financial goals, risk appetite and set asset mix. For instance, as equity mutual funds can be highly volatile in the short term, it is crucial to redeem equity investments nearing maturity and park them in fixed income instruments to consolidate gains. Similarly, as equities perform better over long term than other asset classes, the asset allocation for long-term goals can continue to be equity heavy as it requires more time to recover from volatile markets.
Portfolio rebalancing can also assist in bringing back your financial portfolio to the original asset mix of your portfolio. As different asset classes generate differing returns, your original asset mix will get distorted over a period of time. For example, extraordinary returns yielded by equities during bull market situations can significantly lower the proportion of your fixed income investments in your portfolio. Using your asset allocation strategy for rebalancing your portfolio will help restore the desired asset mix for your portfolio.