When it comes to investing, you can only rely completely on any single type of asset. Instead, it’s better to spread your money into different types of investments, like stocks, mutual funds, bonds, and real estate. It helps reduce the risk of losing all your money if one investment doesn’t do better. In this article, we examine what types of asset allocation are and explore what asset allocation in general means.
What is Asset Allocation?
Asset allocation is the investment strategy to balance risk in which you allocate your money to multiple asset classes, such as equity, debt, stocks, and gold. The primary purpose of asset allocation is to ensure that your portfolio performs well under different market conditions. This can be done by ensuring you have a diversified portfolio of different asset classes, as no asset class performs well at all times.
Importance of Asset Allocation
Asset allocation is important for several reasons:
Risk Management: By diversifying investments across various asset classes, you can easily reduce the risk in the overall portfolio, as the performance of your portfolio is not dependent on one asset class.
Enhanced Returns: You are expected to earn better risk-adjusted returns if you allocate assets per your financial goals and risk tolerance.
Achieve goals: Asset allocation strategies help you in achieving your financial goals as it spread your investments across different types of assets considering your risk-taking ability.
Avoiding Concentration Risk: Spreading investments across different assets prevents overexposure to any single asset, reducing the potential negative impact of a poorly performing investment.
Factors that can affect asset allocation
The process of determining the right mix of assets for your portfolio is a very personal one. When making investment decisions, an investor’s asset allocation decision is influenced by various factors such as personal financial goals and objectives, risk appetite, and investment horizon. Let’s understand these factors.
Time of horizon
Time horizon is the number of months or years an investor is expecting to invest to achieve a particular goal. Different investment horizons entail different risk tolerances. For instance, a long-term investment horizon might prompt an investor to invest in a higher-risk portfolio as the slow economic cycles and high volatility in the market tend to ride out with time.
Risk tolerance refers to an investor’s willingness and ability to lose some or all of their original investment in anticipation of greater potential returns. Aggressive investors, or investors with high-risk profiles are likely to risk most of their investments to get better returns.
On the other hand, conservative investors, or risk-averse investors are likely to invest in securities that preserve their original investments.
Risk vs returns
When it comes to investing, risk and returns are inseparably intertwined. The phrase “no pain, no gain” closely sums up the relationship between risk and reward. All investments hold some level of risk. The reward for undertaking risk results in a higher potential for better returns.
Types Of Asset Allocation Strategies
There is no one-size-fits-all approach to asset allocation, as every investor is unique regarding their investment goals, risk tolerance, age, financial responsibilities, etc. But apart from these investor-specific factors, external factors like market movements, changes in interest rates, etc. , might necessitate a periodic change in the asset allocation strategy.
There are 4 key types of asset allocation strategies:
Strategic Asset Allocation
Strategic asset allocation involves determining and maintaining an appropriate ratio of various asset classes in the investor’s portfolio. This appropriate mix of various asset classes in the investor’s portfolio is determined based on factors such as the investor’s age, risk profile, etc. In this types of asset allocation, periodic portfolio rebalancing is performed to ensure that the proportion of individual assets in the portfolio is maintained at the pre-determined levels.
For example, under the auto-choice option of the NPS, investors can choose the maximum equity allocation between 25% to 75% till 35 years of age. However, after the investor achieves 35 years of age, the equity allocation of the portfolio is reduced by a fixed percentage every year. Therefore, the NPS asset allocation is strategically changed as per the investor’s age.
Tactical Asset Allocation
It is a types of asset allocation strategy which involves tactically changing the proportion of different asset classes in an investor’s portfolio to take advantage of changing market conditions. The main aim of this is to benefit from relatively short-term bullish and bearish conditions in equity and debt markets.
An example of this can include increasing equity allocation in the investment portfolio for the short term during a market downturn to benefit from the lower prices of quality stocks. When markets recover later, these stocks can be sold at a profit to generate higher returns for the investor.
It’s a types of asset allocation similar to tactical asset allocation as it also focuses on changing the short-term allocation of different asset classes to take advantage of changing market conditions.
However, unlike tactical asset allocation, which involves buying and selling investments manually, dynamic asset allocation is performed using automated systems based on financial models.
Investors who want their portfolios managed using dynamic-asset-allocation techniques can opt to invest in balanced advantage funds, also known as dynamic asset-allocation funds.
Age-Based Asset Allocation
It’s a types of asset allocation strategy that considers your age as the key factor in determining your equity mutual fund allocation. Under this strategy, your equity allocation is determined by subtracting your current age from the 100.
For example: If you are currently age 25, then you can have 75% (100-25) equity in your portfolio, and 25% remaining can be debt or any other asset class.
Benefits of Asset Allocation
As you might have realized, asset allocation needs to be customized for individual investors and can require significant effort on the part of the investor. To understand why you need to put in this extra effort of choosing investments, rebalancing your portfolio, changing your investments periodically, etc. , you need to consider its benefits.
Below are some of the key benefits of asset allocation that you need to consider:
Reduction of Risk
TAs asset allocation ensures diversification of your investments, you do not have to depend on a single type of investment to achieve your financial goals. This reduced reliance on any single asset class or investment leads to a decrease in the overall risk in your investment portfolio.
Lower Portfolio Volatility
All investments are prone to some volatility depending on prevailing market conditions. But, while you might not be able to eliminate volatility from your portfolio, asset allocation can help decrease and control it to some extent.
This is because, as you diversify your investment across different types of assets, changing market conditions would prove beneficial for some of your investments so that overall portfolio volatility is reduced.
Market-linked investments like stock, bonds and mutual funds go through cyclical periods of high and low returns even periods of negative returns at times.
One of the key benefits of diversifying your investments across multiple asset classes like equity, debt, gold, etc. is that you maximize your returns during different market highs and ensure downside protection during market lows.
This way your investment portfolio will be ideally placed to outperform the broader market under various conditions.
Helps Achieve Financial Goals
One invests money to achieve key financial goals whether it is a vacation, down payment on a new car, buying a new house, retirement planning, etc. Through asset allocation, it is possible to determine which basket of investments is ideally suited to achieve such specific investment goals.
This is because implementing your chosen types of asset allocation strategy will help you stay on course to help you reach your specific financial goals.
FAQ: Types Of Asset Allocation
When should I change my asset allocation across different investments?
Typically asset allocation in your portfolio should change as you get closer to your investment goals, when your investment priorities change or when you want to take advantage of prevailing market conditions. Key life events like marriage, the birth of a child, the purchase of a house, etc. are some other situations when you should consider changing your asset allocation.
Which types of asset allocation strategy is suitable for me?
No single asset allocation strategy fits the investment needs of all individuals. Hence, you will need to consider your unique situation before you can select a strategy for allocating assets so that you are on track to reach your short and long-term financial goals. In case you need help in determining this, it is a good idea to get help from a financial planner before making a decision.
Is asset allocation the same as diversification?
While diversification and asset allocation are closely related; they are not the same thing. Diversification can be defined as the process of spreading your investments across different asset classes so that your dependence on any single investment option is minimized.
Asset allocation, on the other hand, is a process by which you can decide how much you should invest in each asset class so that your portfolio performance is maximized while overall risk is minimized.
Finding the right asset allocation strategy is essential for achieving your financial goals. By diversifying your investments across different asset classes, you can reduce risk and maximize returns.
Whether you choose a conservative, moderate, or aggressive approach, it’s important to regularly review and rebalance your portfolio to ensure it aligns with your changing needs and market conditions. The key is to find a balance that suits your risk tolerance and investment timeframe.
So, whether you’re planning for retirement, saving for a down payment on a house, or just looking to grow your wealth, understanding the different types of asset allocation and their uses can help you make informed decisions. Start exploring various strategies today to take control of your financial future! Read More – SustVest
Founder of Sustvest
Hardik completed his B.Tech from BITS Pilani. Keeping the current global scenario, the growth of renewable energy in mind, and people looking for investment opportunities in mind he founded SustVest ( formerly, Solar Grid X ) in 2018. This venture led him to achieve the ‘Emerging Fintech Talent of the Year in MENA region ‘ in October 2019.