Understanding Asset Allocation

As the classic proverb says, ’Don’t put all eggs in one basket, Investor also must diversify his/her portfolio into different asset classes. Why? The reason is very obvious – to reduce the risk.

There are mainly 5 asset classes, namely; Equity, Debt, commodity, real estate, and cash. One must allocate his/her savings into different asset classes based on the various parameters and their own risk appetite. Dividing your investment into different asset classes based on different parameters is called asset allocation.

Considering the ease of investing and liquidating, we shall focus on two asset classes – Equity & Debt, to understand the process of asset allocation.

Deciding right Asset Allocation Mix:

One of the most important criteria while selecting the asset class is time horizon.

  • Short Term – If you are looking to invest for less than 3 years, your portfolio should consists of mainly Debt investment as equity is very volatile and market risk is higher in short term.
  • Medium Term – If you are looking to invest for a  period of 3 to 5 years, your portfolio should be mix of equity and debt both.
  • Long Term – In case of investment for longer than 5 years, you can invest more into equity. Equity as an asset class is lesser volatile in long term.

Rebalancing Asset Allocation:

The investment horizon keeps on changing over a period of time. So as the years passed by, asset allocation needs to be re-adjusted based on the remaining numbers of years till you need to withdraw. So for example, if you are going to need money in the year 2027, you must start shifting money gradually from equity to debt by the year 2024.

Other important Parameters:

Risk appetite, the required rate of return to achieve your financial goals, tax implications, etc. are other parameters that are also crucial while deciding the right asset allocation mix.

One must be able to control GREED in the bull market and FEAR in the bear market to ensure the right asset allocation mix in the portfolio. One must be focused and disciplined to save from the emotional decisions which might deviate himself/herself from the asset allocation.

“Most important key to successful Investing can be summed up in just two words Asset-Allocation.” Michael LeBoeuf

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