Asset Allocation

8 min readJun 12, 2022

When studying for exams, students try to cover the maximum number of chapters from their course material. This is because they do not know where the questions will exactly come from. Unfortunately, when it comes to investments, we fail to do the same i.e we do not read all the chapters. Driven by emotions of greed or fear, we invest all our money in just one asset like stocks, bank FDs or gold. The lack of asset allocation has negative effects on wealth creation.

This Blog will answer the fundamental questions like what is asset allocation, how to lower risk by spreading investments in different asset classes, and how you can use simple tricks to allocate assets efficiently.

What is asset class?

An asset class is a group of similar investments. For example, different types of investment assets are categorized into one asset class. Bank deposits and debt mutual funds are different products but they fall into debt/fixed income asset class. This is because they have similar financial structure and are covered by the same tax laws, among others. In this way, equity mutual funds, unit-linked insurance plans (ULIPs), and stocks fall into equity/stock asset class.

Let us have a look at the main asset classes/categories. This will help you to understand the concept better.

1. Stocks or equities — Equities are shares of ownership in a company. You as an investor can potentially profit from equities either through appreciation in the share price or by getting dividends (quarterly or annual). The main asset class of stocks/equities is often subdivided into small cap, mid cap, and large cap stocks.

2. Bonds or other fixed income investments — Fixed income investments are investments in debt securities. These pay the investor a fixed rate of return. Do note that not all fixed income investments offer a specific fixed return. Fixed income investments are considered to be less risky than other asset classes.

3. Cash or cash equivalents — The main advantage of cash or cash equivalent investments is that they can be quickly and easily accessed. It is cash after all. So, one could take out or do anything with it whenever they wish to. Cash helps buy other asset class during sharp price correction. Cash helps the portion of the portfolio to be immune from any sharp drops.

4. Gold — Gold is a highly liquid but equally scarce asset. It is bought as luxury goods as much as a worthy investment. In an investment portfolio, gold acts as a source of long-term returns, a diversifier capable of lowering losses in times of market stress, and a liquid asset with no credit risk. Many argue that globally gold’s long-term returns are comparable to stocks and higher than bonds or commodities.

5. Real estate or other tangible assets — Real estate and other physical assets are considered as a separate asset class. The main draw here is the aim to offer protection against inflation. Financial instruments are only on paper. ‘Real’ assets are physically available.

What is Asset Allocation?

Asset allocation may seem a complicated word for you. But, in practice, all of us use the basic principles of asset allocation in our day to day lives. Asset allocation in terms of investment works broadly by dividing your investment in a number of unrelated asset classes. You decide how much of your investment in rupees will go to which assets. Stocks, bonds, gold, and cash are traditional alternatives. By spreading your investments across a number of asset classes, you reduce the risk potential compared to allocating 100% of your investments in one single asset class. Since all the asset classes do not move in tandem, asset allocation is an easy way to control investment risk.

Goal of asset allocation

The general aim of any asset allocation is simply to minimize losses. If you minimize losses, your gains will automatically be enhanced. Many investors use asset allocation to minimize volatility. For those who do not know what volatility means, here is a small explanation.
For instance, if an asset ‘A’ gives 100% return this year and then falls by 50% the next year, it is highly volatile. All investors want to have asset ‘A’ in their portfolio when it gives 100% return. The same investors would want to avoid asset ‘A’ on a year when it falls by 50%.
By distributing your money across different assets in a proper way, you can avoid bad knocks to your wealth from assets that are likely to fall in value. By having more exposure to assets that have potential to rise, you automatically stand a higher chance of gaining a lot more than others.
Asset allocation works based on few theories. Firstly, all the asset categories do not fall or rise at the same time. Secondly, all the asset categories do not behave in the same way at the same time to the same market

First steps of asset allocation

Asset allocation is important to you if you are new to building wealth. As an existing investor if you have all your financial investments in one asset like stocks, mutual funds or bank FDs, you also need asset allocation. One bad year for the single asset you are exposed to and your wealth can witness sharp decrease in value.

The first steps towards asset allocation needs to be linked to the following:

1. The number of asset categories to be present in your portfolio — There are both traditional and alternative asset categories. In traditional segment, there are stocks, bonds, gold and cash. In the alternative space, there are Real Estate Investment Trusts (REITs), and Infrastructure Investment Trust (INVITs), among others. Do remember the assets you select for proper allocation should be regulated by the government authority and should have proper markets where they can be bought and sold through registered intermediaries.

2. The percentage of allocation to different assets — Will you allocate 50% to stocks, and the rest 50% split equally among debt, gold and cash? Or, will you keep 25% in stocks, 25% in debt, 25% gold and 25% in cash? The answer depends on the size of your portfolio, your risk tolerance, your investment goals, and your time horizon (how long you plan to keep money invested). Though at a fundamental level, all assets are supposed to generate positive returns but every asset is unique in some respect. For instance, stocks or stock-related investments should be given a minimum of 3–5 years. Debt or cash can have less than one year time horizon. If your investment time goal and time horizon does not permit 5 years, your asset allocation plan should not include stocks.

3. Asset allocation model — In static asset allocation, there is an annual rebalancing exercise. It is split between different assets at the same level before the year begins. The other models are tactical allocation that adjusts daily, weekly or quarterly in response to asset market changes. There could be strategic allocation that varies annually if asset classes deviate a lot in terms of returns.

Why is asset allocation important?

Asset allocation helps weigh stocks, bonds and cash in a portfolio in a way. The critical first step is portfolio construction. Too much in bonds or cash will ensure lower volatility, but may not produce enough returns to meet return objectives or keep ahead of inflation. Conversely, too heavy a weight in stocks can produce higher rates of return over time, but can also be subject to large swings in value over shorter periods of time.

Advantages of asset allocation

The asset allocation investment strategy offers some advantages, like:

1. Returns — The frequent adjustments in the mix of assets can possibly provide higher returns on the investment portfolio. The portfolio adjustments can prevent losses from unexpected market downturns and capture the momentum to increase the returns.

2. Adjustment to market changes — Unlike the static asset allocation, dynamic asset allocation is highly flexible. A dynamic strategy can quickly respond to market changes and market risks.

Disadvantages of asset allocation

An asset allocation strategy is not flawless:

1. Transaction costs — There are frequent rebalancing of weights inside the portfolio. This means transaction costs and portfolio turnover can be higher.

2. Active management — While asset allocation involves active management, the investment manager’s skill is extremely important in maintaining a tight control of the investment portfolio. When there is a change of manager, the skill level as well as execution capabilities are liable to change too.

Need for diversification

Diversification is the practice of spreading your investments around. This ensures your asset exposure to any one type of asset is capped. This practice is designed to help reduce the volatility of your investment portfolio over time.
One of the keys to successful investing is learning how to balance your comfort level with risk against your time horizon. If you invest your retirement corpus too conservatively at a young age, you run the risk that the growth rate of your investments will not keep up with inflation. If you invest too aggressively when you are older, you could leave your savings exposed to market volatility. This would erode the value of your assets at an age when you have fewer opportunities to recoup your losses
One way to balance risk and reward in your investment portfolio is to diversify your assets. This strategy has many complexities, but at its root is a simple and powerful idea. This means spreading your portfolio across several asset classes.
Diversification can help mitigate the risk and volatility in your portfolio. This can potentially reduce the number and severity of stomach-churning ups and downs. Remember, diversification does not ensure a profit or guarantee against loss.

Important Points to remember

Asset allocation, not just investment selection, guides long term financial returns
Balance risk and reward for the long-term with asset allocation.
Avoid too much exposure in one asset class.
All the assets at the same time do not move in the same way.
Goal of asset allocation is to protect you from declines.
Know your investment goal, investment horizon and risk tolerance.
Take a measured approach if you opt for static asset allocation.
Asset allocation is good for investors who simply don’t have the skill or time to re-balance.
Despite best attempts, you may not become a roaring winner.
Asset allocation is the best way to optimize risk and return for long-term investors.

Thanks for reading the Article

Originally published at https://www.yourcaguide.com on June 12, 2022.