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You should have a strategic asset allocation mix that assumes that you don\u2019t know what the future is going to hold.<\/p>\n
-Ray Dalio (American billionaire, hedge fund manager, philanthropist)<\/p>\n
The one thing I have learned since starting on this Personal Finance journey is the fact that no one can predict the future, be it in interest rates or market performance. With that knowledge, as Ray Dalio says in the quote above, it becomes imperative to follow an asset allocation like a route map. This complete guide will resolve all your queries about asset allocation.<\/p>\n
Investopedia<\/a> defines asset allocation as – Asset allocation is an\u00a0investment strategy\u00a0that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals,\u00a0risk tolerance and\u00a0investment horizon.<\/p>\n This definition is quite a handful and it makes sense to break it down. As pointed out, it is an investment strategy that helps in dividing your investment funds into various classes. The 3 factors that determine your asset allocation are:<\/p>\n As mentioned earlier, goal-based investing<\/a> gives a far better idea of our destination and reason for investing. Your goal also determines the other two factors of risk tolerance and investment horizon.<\/p>\n Once you know your goal, you have a clear idea about the time horizon for which you can invest. So, if your child is 8 years old today and you know your need for his education expenses at 18, your time horizon is ten years<\/p>\n This has a lot to do with time horizon and even back up funding for the goal. With a longer time horizon, like 20 years to retirement, higher risk can be easily tolerated. As for the goal, suppose along with your investment for retirement, you are also eligible for a pension that you are looking at as bonus money and not accounting in your calculation for the retirement corpus, your risk tolerance would again be higher as your dependence on the corpus and it\u2019s performance gets lowered.<\/p>\n There are various levels of allocation that you can look at. For most purposes, asset allocation is restricted to the asset classes of debt, equity and gold. In most cases, real estate just ends up toppling the asset allocation balance unfavorably, hiding any picture it could provide. If the assets in the other classes increase in the amount to reach the real asset levels, then you could look at including real estate in your asset allocation mix.\u00a0 Debt refers to investing done through bonds or debt mutual funds whereas investment is gold today is mostly done through gold funds or ETFs rather than holding on to the metal.<\/p>\n In the first level, you would need to decide your bifurcation of funds into the main asset classes like debt, equity and gold. One of the most widely recommended asset allocations is 10{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} gold, 20{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} debt and 70{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} equity. However, considering the shoddy performance of Gold ETFs in India<\/a> in the recent past, you could consider dividing your allocation just among debt and equity.<\/p>\n Another rule of thumb is to invest in equity as a percentage of 100 \u2013 your age. So, if you are 32, this rule tells you to invest 68{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} of your portfolio in equity with the remaining in debt. Since one size does not fit all and your age cannot be a real determinant of asset allocation, I am not much of a fan of this rule.<\/p>\n Ideally, fix an asset allocation for all your goals separately as they will follow a path of their own. For instance, when you are about 1 or 2 years away from needing the funds for your child\u2019s education, it is ideal to put them in risk-free instruments to avoid them from the uncertainty of markets.<\/p>\n Within the major asset classes also, there is a decision to be made as to what kind of allocation will be made. For instance, if you are investing in equity, what proportion of the funds will be devoted to the stable option of mutual funds<\/a>, and how much time and funds are you willing to devote to stock<\/a> picking.<\/p>\n Similarly, for debt funds too, you can make a decision as to the allocation of funds to the safer option of government bonds<\/a> or corporate bonds<\/a> or even credit risk funds<\/a>.<\/p>\n Even after a decision of how much to invest between direct stocks and mutual funds, you might want to tune it down further to decide the allocation between the different type of equity classes \u2013 large, mid and small cap.<\/p>\n Another way of allocating assets is to diversify by geography by investing some assets in foreign lands. However, that should be done only at an advanced level as the home advantage means you will be far more aware of your own market than any other.<\/p>\n If you are thinking that this is too much work, then read on to know the merits and the importance of following an asset allocation policy in your portfolio.<\/p>\n As they say \u2013 do not put all your eggs in one basket. Ensure that your portfolio has inversely moving asset classes. By that I mean, asset classes like debt and equity generally follow opposite directions of movements \u2013 when one rises, the other falls and vice versa. This diversification is key to safeguarding your losses and achieving relatively okay results even in a bear market.<\/p>\n Sure, you can turn around and say that diversification brings down returns in a bull market. That\u2019s why we started with the Ray Dalio quote \u2013 you need an asset allocation mix because it protects you from the unpredictability of the markets. Almost like an insurance policy for your investing.<\/p>\n In most cases, risk and return are directly proportional, requiring an investor to take higher risk for a higher potential return. Asset allocation plays on this trade off by moderating both \u2013 the risk and resultantly the return and brings them down to a level that you can sleep peacefully with the knowledge of.<\/p>\n We all earn, save and invest money as a means of fuelling our financial dreams and goals. With asset allocation, we are putting those goals at the centre and as the main objective rather than a \u201cwho can get a higher return\u201d contest with hard earned investing money.<\/p>\n Asset allocation ensures that you need to make only minor tweaks or look at portfolio rebalancing only once in a while. It is pretty much a lock it and forget it portfolio management practice where checks and rebalancing possibility even once a year are good enough (unless you are investing in stocks where once a quarter or maximum once a month is preferable).<\/p>\nGoals<\/span><\/h4>\n
Time Horizon<\/span><\/h4>\n
Risk tolerance<\/span><\/h4>\n
Levels of asset allocation<\/strong><\/span><\/h3>\n
First level of asset allocation<\/span><\/h4>\n
Second level of asset allocation<\/span><\/h4>\n
Third level of allocation<\/span><\/h4>\n
Geographical asset allocation<\/span><\/h4>\n
Why is asset allocation important?<\/span><\/h3>\n
Diversification<\/span><\/h4>\n
Risk-Return Tradeoff<\/span><\/h4>\n
It puts goals at the centre of the equation<\/span><\/h4>\n
Low maintenance<\/span><\/h4>\n
Reduces dependence on individual picks<\/span><\/h4>\n