Importance of asset allocation
Think about the food you eat daily. Do you only eat food that belongs to one food group or is it a mix of carbohydrates, fat, protein, and vitamins? Just like your body needs a good balance of different food groups, as each performs a different, vital function, your investment portfolio requires a good balance of different types of investments that carry different risks and returns. This is what is known as asset allocation.
Asset allocation is important because it helps reduce risk by diversifying. If one investment is not performing well, your overall portfolio returns won’t take a massive hit as long as there are other investments of different kinds. Different assets also help in meeting different types of financial goals over varied periods.
Different asset classes
Primarily, when one talks about asset allocation, they talk about the allocation of funds between equity and debt. The equity asset class relates to the stock market and includes investments such as stocks of companies, equity mutual funds, equity Exchange-Traded Funds (ETFs), and other equity-related assets. Equity investments are known to be high-risk because they are market-linked, and the stock market is characterised by volatility. This means the price of stocks fluctuates due to several macro and microeconomic factors and nobody can predict or time the market. However, on the flip side, equity investments are also known for generating high returns. This, again, is because of market volatility which, when works in your favour, can help you earn capital gains.
When it comes to debt investments, they are also known as fixed-income investments. That’s because they help you earn a fixed return based on a predetermined interest rate. Debt investments include bonds, treasury bills, fixed deposits, debt mutual funds, commercial papers, and more. Debt investments are known to be safer because their price does not fluctuate like stocks. Hence, the risk of capital loss does not exist. Debt investments help with capital preservation. The returns, however, are also lower when compared to equity investments.
Factors that help determine asset allocation
The type of asset allocation your portfolio should have depends on two important factors such as your risk tolerance and investment horizon. Let’s see how these factors help in determining the ideal asset allocation for you.
1. Risk tolerance
Your risk tolerance is the amount of risk you can and are willing to take when you make investments. It depends on a number of factors including your income, living expenses, debt you’re servicing, number of dependents, age, and personality type. For instance, if you are someone who has no dependents, no debt, and are someone who is okay with the possibility of losing money at the off chance of earning higher returns, then your risk tolerance is high. And this would mean that you can have a greater proportion of equity investments in your portfolio as compared to debt.
2. Investment horizon
Investment horizon is the period for which you will stay invested in an asset. This depends on the type of asset you’re investing in and is closely linked to your financial goals. For instance, if you have a long-term goal such as saving up for the down payment of your home and you have eight years to meet it, you can consider investing in equity investments like equity mutual funds. It’s always best to invest in equity investments when you have a long investment horizon because you give your investment enough time to iron out any short-term fluctuations and hedge market risk.
How to figure out what’s the ideal asset allocation for you?
It can be tricky to determine what the ideal asset allocation is for you based on your risk tolerance and investment horizon. Many investors continuously undertake portfolio rebalancing to try and get the asset allocation right. Here is where an asset allocation calculator comes in handy. An asset allocation calculator takes into account your age, risk tolerance, and investment horizon and gives you a percentage-wise breakdown of where you should invest your money. It won’t just tell you how much to invest in equity and debt but will also break down what kind of equity and debt instruments should you invest in and to what extent.