Asset allocation is essential to the goal of long-term wealth creation. It involves dividing the portfolio and investing in a combination of different asset classes like debt, stocks, real estate, gold, etc. Therefore, the principle of asset allocation is complementary to the concept of diversification.
Asset allocation is based on the three pillars of any successful investment plan: risk tolerance, financial goals and time horizon. Risk tolerance is your ability and willingness to lose some or all of your initial investment in exchange for greater potential returns. You can determine your risk tolerance by taking a risk profiler which is a psychometric test that determines what level of loss you would be comfortable with in situations of extreme market volatility and what your asset allocation should be at risk (read equity).
However, risk tolerance alone cannot determine your ideal asset allocation. Understanding and spelling out your goals (cash needed for a specific goal) and their time horizon are the other key determinants. You need to create a combination of assets that has the highest probability of hitting your goal at a level of risk you can tolerate. As you get closer to your goal, you will also need to adjust the asset mix. Sometimes additional information on cash inflows and liquidity needs is also needed to arrive at an asset allocation framework.
For example, if you have a financial goal like long-term retirement planning, you’re likely to get higher returns from higher-risk asset classes, like stocks or equity-oriented mutual funds. and long-term bond funds. However, if the goal is short-term, such as buying a car or house next year, investing only in liquid or short-duration funds may be ideal. Therefore, asset allocation may vary with different objectives and their concomitant time horizons.
Asset allocation is an iterative and dynamic process. You may need to change your asset allocation if your financial situation or financial goals change. Most importantly, for successful and planned results, the discipline of timely rebalancing cannot be overstated and this is where the role of a financial advisor becomes very important as the human instinct is to reduce equity during market corrections and to increase them during a bullish cycle. Ideally, a portfolio should be rebalanced at semi-annual intervals for medium-term goals and at annual intervals for long-term goals or in the event of extreme deviation during sudden market movements on either side. Although rebalancing, exit charges and tax impact should also be kept in mind.
A single portfolio can also have three layers of asset allocation: Strategic asset allocation – this forms the core of its portfolio and should be as close as possible to its risk tolerance. Tactical allocation – this involves taking tactical calls on margin, depending on personal circumstances (higher allocation to fixed income securities for short-term goals or higher allocation to equities during severe stock market corrections). Dynamic Asset Allocation – This style of asset allocation may work for you for the part of the portfolio that is not assigned to a specific objective. The rebalancing is entirely based on macroeconomic and market-related parameters.
Wealth creation is said to be more a function of proper asset allocation than stock or mutual fund selection. Regardless of the quality of a stock selection or program, optimal allocation can dramatically increase returns. Disciplined adherence to asset allocation results in superior risk-adjusted returns or, quite simply, a smoother journey through the investment journey compared to investing in a single asset class.
The opinions expressed above are those of the author.
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