Contributed By: Team NJ Publications
From the time one decides to invest their money, they come across a world which offers them a variety of options to invest in. We would always want our hard-earned money should provide us with the ‘maximum returns’ which could satisfy our needs and wants.
Every investor has a different risk profile, financial history and different expectations about the future and they expect a return according to these criteria. They search for an asset class which resonate with their investment objectives. But the question arises whether a particular class of asset could help the investor in every situation of the investment journey?
The saying, ‘don’t put all your eggs in one basket’, has become a valuable metaphor for explaining why we should not direct our investments in only one asset class and why diversifying through asset allocation is important.
What do we mean by Asset Allocation?
Asset allocation could be defined “as an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance and investment horizon.” The three main asset classes - equities, fixed-income, and cash and equivalents - have different levels of risk and return, so each will behave differently over time.
Asset allocation establishes the framework of an investor’s portfolio and sets forth a plan by specifically identifying where to invest one’s money. The theory behind asset allocation is to spread your investments across different asset classes to help protect your portfolio from downturns in any one asset. Since different investments are affected differently by economic events and market factors, owning different types of investments helps reduce the chances that your portfolio will be adversely affected by a particular risk type.
As already mentioned, the investments can be in the following asset classes:
Stocks/Equities – Stocks, or equities, have historically offered the highest risk and highest returns.
Bonds & Fixed Income – Bonds have historically had less volatility than stocks, but the trade-off is that they offer more modest returns.
Cash & Cash Equivalents – Cash and equivalents are the least risky asset class since there’s very little risk of losing capital. In addition to cash, these investments might include certificates of deposit, Treasury bonds, or other cash-like securities.
Benefits of Asset Allocation:
Asset allocation is very important as it serves various benefits as against having a concentrated portfolio of just one basket. Buy a mix of things like shares and commodities for higher potential growth and bonds and property for some stability. And avoid being too biased towards one market. Thus, asset allocation is essential to ensure that you reach your financial goals.
Optimal Return: In the absence of proper asset allocation, many individuals invest in an ad-hoc manner. This, in turn, makes it difficult for them to determine whether the return on investments is sufficient enough. Thus, proper asset allocation will help you determine how much return you can expect on your investments based on investment risks you are taking.
Risk Minimization: Based on your past investment experience or your willingness to take the risk you will make your future investments decision. If you want to earn higher returns by taking more risk, you can have the majority of your asset allocated in equity. But if you are in your retirement age and want to earn less volatile returns, investment in bonds or money market securities is the better option
Help investments align as per Time Horizon: Along with the risk profile, your time horizon is also a key factor to decide the asset allocation, while you endeavour to achieve your financial goals. Your time horizon will determine in which asset class you should invest a dominant portion of your investible surplus.
Minimize Taxes: If you happen to be under 30% tax bracket and invest all your savings in fixed deposit to keep your investments safe, then you are making a big mistake by paying a huge amount in taxes, which otherwise could have been legitimately saved. Tax consequences are different for every individual and every scenario so you should always view investment returns for post-tax returns on investments rather than pre-tax returns as the post-tax return is the return which you get in your hand
Diversification: ‘Put your eggs in different baskets’. One way to lower your risk without sacrificing the potential for higher returns is to spread your money more widely. Historically, the returns of stocks, bonds, and cash haven’t moved in unison. Market conditions that lead to one asset class outperforming during a given time frame might cause another to underperform. The result of diversifying is less volatility for investors on a portfolio level since these movements offset each other. This ultimately leads to “egg-cellent” returns.
How much to allocate?
There is no simple formula that can find the right asset allocation for every individual. However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make and the principal determinant of the returns from the portfolio.
A majority of financial advisors advice asset allocation based on the age profile and/or life stage. Typically one can use a crude formula of 100 (-) current age to derive at the proportion of investment into equities. Thus if your age is 40, investment into equities will be 60%. the figure of 100 may even be considered as 110 or 120 depending on your life expectancy or risk orientation. However, the proper asset allocation suitable to you and your needs should be decided in consultation with your financial advisor.