Asset allocation is the method off allocating investor’s funds to each type of investment (eg. Mutual Fund, Stocks, Bonds, FD etc.) by balancing the risk and reward based on each individual’s risk taking level, purpose of investment and the duration of investment.
By this method of diversified investments across different asset classes, you can maximise the risk – reward balance of your portfolio. This also ensures that the poor performance of any one asset will not collapse your entire investment plan.
What are the main Asset classes in India?
Stocks, Bonds and Cash are the most common asset classes. Each of them have different qualities and strengths, as well as risk / reward characteristics.
Stocks – Highest Risk – Return Potential
Stock investment can earn and lose money based on the increasing or decreasing market value of the share. The price movement of stocks are very drastic, which can make or lose money very fast. Hence it is the most riskiest one.
Bonds – Low Risk – Return potential
Bonds or fixed income investments are money loaned to the government, municipalities or other entities). They can earn money from the interest paid on that loan. Since the money is borrowed by government authorities the investment risk is very less.
Cash – Lowest Risk – Return potential
Cash or Cash equivalents are Treasury bills, certificates of deposits and other short term securities. They earn you money through interest, which is usually set at a guarantee rate.
As noted above, each asset class has different levels of potential risk and reward. When these are combined together, we can create a diversified and balanced investment portfolio. A sound investment takes both risk and reward potential into account. Investing across different asset classes can add diversification and help to manage the risk. Tuning the mix of asset types – your asset allocation strategy – can have a significant impact on your ability to reach your investment goals.
Why do we need asset allocation?
Whenever you diversify across asset classes you give yourself the margin or flexibility to counter the market uncertainties. Inherent in asset allocation is the idea that the best performing asset varies from year to year and is not easily predictable.
Factors that can affect Asset Allocation
Decision on asset allocation is based upon each person’s risk appetite. Risk appetite basically says how much risk one can tolerate on his investments to achieve maximum returns. Following indicators give more insight to your risk appetite
- Your Age : It is the greatest indicator of your risk appetite. A young person can afford to take greater risk on his investment portfolio because the horizon of his investment is larger than aged. He has a increased potential for higher return. An older person would prefer to have a lower risk appetite due to increased responsibilities.
- Investment Period : People of the same age may not have the same risk appetite due to their different planning horizons. Some may be targeting an investment for his Son’s education. Other may be for his daughter’s marriage. Hence the investment horizon (period) can vary even if they are of same age.
- Market Conditions : Sometimes the current market conditions and the volatility of the markets can change your risk appetite. If the market is having a very high volatility rates, many would never try to invest in Stocks, since the chances of losing money is higher and faster.
- Personal Circumstances : It can also be possible that at times your risk appetite may reduce due to certain incidents in your life. This would trigger to reduce the level of risking your money in certain asset classes.
Why should we modify Asset Allocation?
Asset Allocation shall be altered as and when depending on the factors like Age, market conditions or personal circumstances. Reallocation is the process by which you can change the asset allocation percentages on your plan.
Recommended Read :
- Methods to Select the Best Mutual Funds
- What are Mutual Funds?
- Types of Mutual Funds in India
- 5 Types of Popular Mutual Funds in India
- Understanding Mutual Funds Returns?
- Fixed Deposit Vs Mutual Fund
- Real Estate Vs Mutual Fund
- SIP Vs Mutual Fund
- Mutual Fund Investment Strategy
- Mutual Funds in India
- What is Net Asset Value (NAV)?
- Open Ended Mutual Fund Scheme
- Close Ended Mutual Fund Scheme