The main benefit of asset allocation is to build a more stable portfolio. It also helps diversify and provide stability to the portfolio and better risk-adjusted returns.
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While investing, rather than choosing between debt or equity mutual fund to invest in, it is important to decide how much money should be invested in equity, debt, and other asset classes. Experts say, to grow their capital, investors should focus on asset allocation, and decide where and how much to invest. Asset allocation is a method to allocate one’s investments in different asset classes like equity, bonds, gold, and cash to reduce risk and generate reasonable returns.
Suraj P Shroff, Founder, Infiniti Investments, says “For asset allocation to give results, the investments should be in assets which are not completely co-related to each other. For example, investing in 10 equity funds or FDs of 10 banks is not truly asset allocation.”
Benefits of asset allocation
The main benefit of asset allocation is to build a more stable portfolio. Shroff, of Infiniti Investments, says, “Putting all your eggs in one basket is not advisable; similarly asset allocation can help diversify and provide stability to the portfolio and better risk-adjusted returns. Good asset allocation can help improve portfolio returns in the long run.” Hence, if you timely rebalance your portfolio, you will automatically be taking profits off the table and reinvesting in asset classes that have had a bad patch.
How to decide on asset allocation?
Before looking at the important factors that help in the asset allocation process, note that asset allocation varies from individual to individual.
1. Time horizon: It is one of the most important determinants while allocating your assets. Shroff, says, For a long-term goal, the focus would be on growth and higher returns and hence, more allocation to growth assets like Indian and international equity.” For short term goals, as one focuses more on liquidity and stability, the allocation should tilt towards bonds and liquid funds.
2. Risk tolerance and return expectations: They are some of the key criteria to decide on asset allocation. For an individual who is not comfortable with market risks, the allocation between equity and bonds would tilt towards bond funds and FDs. Experts say the biggest risk that most people ignore is the risk of inflation and the fact that they may end up with a corpus which is way lesser than what is required due to the preference for safe investments. Shroff, says, “Markets are expected to be volatile and hence, asset allocation can improve returns in the long run and reduce volatility as well.”
3. Concept of tactical asset allocation: This is a slightly advanced variation within asset allocation. Shroff, says, “Under the tactical asset allocation concept, a portion of the portfolio which is more dynamic is allocated to asset classes with a shorter horizon in mind to take advantage of a particular situation or a temporary opportunity is a smaller segment of the market, which could be sector funds/alternative investments, etc.” According to experts, typically, not more than 15-20 per cent of the portfolio should be a part of this tactical asset allocation as this a more aggressive strategy.
How and when to rebalance or maintain the desired asset allocation?
In the initial years, as an investor, you should rebalance your portfolio once a year. Shroff, says, “Over the years, once the portfolio is larger, an investor could look at rebalancing possibly once in 6 months.” To ensure a tax-efficient process, experts say, the first option is to redirect future investments into asset classes where you need to increase allocation instead of the other asset classes. The other option would be to switch out a portion of the existing portfolio to rebalance.