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Last Updated : Sep 16, 2014 05:20 PM IST | Source: Moneycontrol.com

How important is asset allocation?

Asset Allocation refers to apportionment of assets to different asset classes based on individual preferences, goals and risk profile.

Smitha Hari

Asset Allocation refers to apportionment of assets to different asset classes based on individual preferences, goals and risk profile. Based on the principle of diversification, asset allocation helps in limiting risks and reducing volatilities of returns. It is important to look at the financial position in totality before deciding on the asset allocation. As the needs can change over time, it is important to regularly review the asset allocation and re-align whenever necessary.

Asset Allocation is popularly defined as the way an investor assigns his assets to different asset classes, according to various factors such as his risk tolerance, risk appetite, goals and investment timeframe. Asset allocation is extremely critical to how the investor’s portfolio performs. There are several studies which talk of the importance of asset allocation and financial planners also stress on this requirement. However, this is a highly neglected aspect by most investors. More importance is given to what stocks or mutual funds one should hold. While this is needed, what is more essential is for an investor to first decide the mix of asset classes he should have.

There is no one simple, straight forward solution to Asset Allocation. This depends on the individual’s factors and unique requirements. Nevertheless, it is imperative that asset allocation is adopted while planning finances, and constantly reviewed as well.

Asset Allocation primarily works on the principle of diversification. Simply put, this is something which is oft repeated by experts - do not put all the eggs in one basket. Attaining a fine balance between risk and returns is what achieves an ideal portfolio. Both movable and immovable investments are diversified across different asset classes so that at the portfolio level, losses are limited and volatilities of returns are reduced.

How to do Asset Allocation? One should look at all aspects of his/her finances while allocating assets. Understanding risk tolerance and risk appetite is very important before deciding on the asset allocation. For this purpose, it is recommended to undertake risk profiling tests which are available on the internet or with a financial planner. It is also important to be cognizant of one’s financial goals and liabilities. Online calculators or financial advisers help investors in arriving at the ideal asset allocation. It is also possible to understand which asset allocation best suits you by working backwards from your goals - estimate the return on investment which is needed to achieve the goals and choose the portfolio which can give you this return. Once an ideal asset allocation is arrived at, the current asset allocation should be mapped to this and steps should be taken to eventually move to this. Asset allocation once achieved should be periodically reviewed and re-aligned, if needed, depending on changing circumstances and needs.

Models of Asset Allocation: Asset Allocation models can work to achieve a portfolio which is Aggressive, Moderate or Conservative. These are three broad buckets. Within this, one can further classify it as Moderately Aggressive and Moderately Conservative. As mentioned above, the classification depends on the risk level, goals and surplus funds.

Benefits of Asset Allocation: Diversification of assets is an important benefit of asset allocation. As a result, the risk is reduced and returns are more stable. Asset allocation is also important to achieve goals. A long term goal can be achieved by having more aggressive assets such as equity mutual funds, while it is better to invest in safer assets to achieve short term goals. This balance is brought about by asset allocation.

How to avoid an imbalance: An incorrect asset allocation can upset finances. It is important to avoid this imbalance. Consumption and investment needs should be segregated. For example, if gold will be a critical asset in your child’s marriage, then the proportion of assets allocated towards gold should be increased. While allocating assets, the post tax return should be considered. It is recommended to choose avenues which can help in beating inflation rates over the long term. Risk and return are co-related. Hence, choosing investment avenues according to goals and timeline of goals can help in avoiding an imbalance in asset allocation. It is also important to look at your asset position in totality. For example, an investor with ongoing investments in employee provident fund is already investing in debt, and therefore may avoid fixed deposits for the long term. This is of course subject to other factors such as risk profiling and individual preferences.

Review of Asset Allocation: Achieving an ideal asset allocation position is not an end by itself. Change in goals can alter the asset allocation. For example, when one nears a goal, it is better to move to safer assets like debt. Similarly, time can also bring about a need for change in asset allocation. Risk capacity and risk tolerance can change over time. Also, as one becomes old, there is usually a preference to move away from volatile assets to safer avenues.  Hence reviewing the asset allocation position and re-aligning when needed is absolutely necessary.

Asset Allocation is critical for a successful investment portfolio. That said, it should be remembered that this is highly subjective and varies from person to person. Also, for the same person, it changes from time to time. Regular review and modification is necessary in the asset allocation process.

The author can be reached at smitha@gettingyourich.com. The above are suggestions only and readers should consult an adviser before making any decision.

First Published on Sep 16, 2014 05:20 pm