Asset allocation is the implementation of an investment strategy that seeks to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio based on the investor's risk taking capacity, goals and the time frame needed to reach those goals. The objective of asset allocation is to minimise volatility and maximise returns. The process involves dividing your money among asset categories that do not all respond to the same market forces in the same way at the same time.
Asset allocation will vary from one investor to another. For example am aggressive investor can have 75% in equity mutual funds, 20% in fixed income funds and 5% in gold.
How does an investor implement asset allocation?
Before starting to invest in financial products, ideally an investor needs to decide his asset allocation. He can do this himself or take help from a financial planner, who can suggest an asset allocation based on his assessment of his profile. For example, an investor wants to invest ₹10 lakhs, he cold allocate 50% to equity mutual funds, 45% to debt mutual funds and 5% to gold funds. This is supposed to be monitored on a regular basis. So after a year, if due to a rise in the stock markets, if the equity mutual fund allocation rises to 60%, it should be brought back to its original level of 50%. Similarly if additional money needs to be allocated to this portfolio, it should follow the same principle. This is necessary as otherwise if equities fall due to any untoward event, it could result in a higher loss to the portfolio. Wealth managers said sticking to an asset allocation plan is crucial to achieving financial goals. This approach reduces risk on the portfolio too. When equity component goes up, the investor can bring back his allocation by switching some units back to debt funds. Similarly when allocation falls due to a fall in the market, he can increase it to his original allocation by switching from debt funds to equity funds.
How does it pay to follow asset allocation?
Financial markets are full of surprises and it is difficult for any individual to predict which asset class will go up or down. For example, equities may be up, while gold may be down and vice versa. However if you have your wealth spread across assets, you will be less hit and get the best risk adjusted returns. Financial planners believe that in the long term, 90% of the returns come from proper asset allocation.
How often should one review asset allocation?
Investors should review it atleast once a quarter. If any asset class moves up or down by more than 10% of their targeted allocation, they could look at rebalancing their portfolio.
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