What is asset allocation
Asset allocation is a process of diversifying your investment portfolio in different asset classes of varying risk in order to mitigate the overall risk of the investment and procure higher returns.
It is an investing strategy that divides an investment portfolio across several asset classes such as stock, fixed income, debt funds, real estate, and so on in order to balance risk and reward.
The common way of defining asset allocation could be “Do not put all your eggs in the same basket”. This is done to ensure that even if one of your assets fails to give the optimum result, your overall investment portfolio does not turn up side down.
Importance of asset allocation
Different assets perform differently with time. During the bull market, the growth stock can out perform the large cap stocks. While, during the times of market crash, Gold bonds can fetch positive returns.
One needs to understand that all assets do not move with the same momentum and direction. Hence, in order to protect the investor from high risk and ensure goods returns, one needs to plan his asset allocation.
There is a concept of conformation bias. This theory states that people tend to take the decision first and later try to find data to back their argument. This leads to investors take irrational decision and do poor risk management on their investment.
Thus, proper asset allocation will ensure that your investment portfolio does not get deteriorated due to events of economic crisis and ensure a handsome return in the long term.
Ways to achieve optimum asset allocation
Risk appetite
The degree of risk appetite of an investor plays a crucial role in determining the asset allocation. An young investor has a higher degree of risk tolerance than a matured investor.
Risk appetite is a factor that is dependent on the age of the investor. A young investor can expose himself to high risk investment classes. On the other hand, an aged investor needs to focus more on stability.
Risk appetite in your 20s
When an investor starts his investment journey in his 20s, he has the maximum potential to take high risk. In this stage of investing, one can try out different avenues of investment like cryptocurrency.
Investing in crypto is a high risk high reward game. One needs to only invest that portion of the amount that one can afford to lose and will not affect your overall portfolio.
At this age, invest major chunk of your money in equity as you can take the advantage of staying invested in growth companies for a longer duration. Also one can focus on growth stocks and particularly select stock in small cap or mid cap range.
Also ensure that you are investing (even a small fraction) in Gold, particularly Gold Bonds. This is because Gold acts like a hedge to your equity portfolio. So when there is an event of market crash, Gold investment can be a life saver.
Optimal asset allocation that should look in your 20s
Risk appetite in your 40s
This is a stage when one needs to be a little serious with your investment. In your 40s you need to focus more on stability rather than high risk stocks. Avoid risky investments like crypto in this stage.
A smart investor can start slowing booking the profits gained from Equity and transfer in Debt to ensure that the profits gains are stabilized. Also, continue increasing your investment in Gold as it will protect your equity investment.
Optimal asset allocation that should look in your 40s
Risk appetite post retirement
Once you reach your retirement, one needs to be absolute stable with the returns and gains to be protected to enjoy the benefit in your post work life.
During the retirement life, the investor may not have a stable source of income. Thus, one needs to protect the surplus gains.
It is important to understand that, one small mistake in your retirement can wipe out major chunk of your capital.
Protect majority of your gains by switching to debt funds. Invest only a small portion in large cap equity that can fetch you a good dividend income.
Optimal asset allocation that should look in your post retirement period
Duration for staying invested
If one is certain that they can stay invested for a longer duration then one can allocate major part of their assets in equity segment.
To enjoy extra ordinary returns from equity, one needs to have the caliber of staying invested for a long duration of time. This duration should at least go up to 30 years for the results to be visible.
There are instances in investors life where one needs to continuously remove funds on regular basis to support his basic needs. If you fall under this situation, consider investing major portion of your funds in debt.
Diversifying at the right time
As and when the smart investor matures in age, he needs to keep repositioning his assets and slowly move the profits gained from high risk assets to low risk assets.
Following this step will ensure that one does not lose the profits earned over a said duration on a black swan event like COVID-19 pandemic or other economic crisis in the future.
Also having major portion in Debt, one will have adequate capital to invest back in Equity when they will get a right opportunity to enter at right valuations.
Other sources of income
This is an added advantage for investors who have more than one source of income. Having multiple income sources provides an edge to investors to increase on the risk appetite and invest in equity.
Conclusion
I have seen many a times people claim themselves to be high risk takers, but are not very sure what they are involved in. One only tends to look at the extra ordinary returns and takes risk more than needed.
Investors need to understand this aspect and make sure to rightly diversify the portfolio in such a way that even if your highest risky investment goes bust overnight, you don’t lose your sleep over it.