If there are two things that investment advisers and portfolio managers swear by, they have be portfolio diversification and asset allocation. Both strategies have stood the test of time to help generate wealth in the long term and reduce the impact of volatility. Although there are no formulas or short-cuts, asset allocation can help you create a fool-proof investment portfolio.
Eventually, you will develop an understanding of making immaculate buy and sell decisions and for selecting the perfect investments. However, before entering the complex market of investing and reaping benefits from it, you must have a thorough knowledge of asset allocation.
Let us understand the process of asset allocation, how it works, and what strategies you should use.
What is asset allocation?
Asset allocation acts as an investment strategy that sections your investment portfolio among different asset classes to balance the overall risks and benefits. The purpose is to minimise the risk of your investment portfolio even as it captures growth opportunities from the market. A permutation of suitable assets with lower correlation is combined into a portfolio. This is done in such a way that should one asset experience a dip in market value, the portfolio is buoyed up by the other assets. What this does is that there is a balance of risk and return created in the portfolio. Additionally, age and risk-appropriate allocation of funds are done to different assets. This ensures that liquidity is maintained along with capital protection.
Each asset class functions differently. Therefore, your aim should be to allocate the assets in your portfolio according to your risk tolerance, investment horizon, and goals. Sebi-Registered Research Analyst at TejiMandi consider all these factors before coming up with a unique asset allocation strategy that best suits your profile. Do check out Teji Mandi Portfolios here.
Let us find out about the different types of asset classes in detail.
What are the different types of asset classes?
Some of the most popular asset classes for you to consider are:
Usually regarded as the riskiest of all major asset classes, equity (stocks and other equity-related instruments) offer the best growth potential. This is because the reward for high risk is a high return.
Stocks are overly volatile and hence very risky for short-term investments. However, if you are in for a long period, inclined to ride out the volatile returns, then equity will give you greater yields.
Returns of equity are based on how they perform in the market. The performance is controlled by numerous economic, political, social, and other macroeconomic factors. This makes equity one of the most volatile asset classes in the market., But, if planned correctly, it can make wealth for you. TejiMandi’s experienced investment professionals help you do this by investing in fundamentally strong stocks through their expert-curated portfolios with the best potential to generate returns.
Fixed income broadly includes government bonds, corporate bonds, money market instruments, government securities, and corporate debt securities. These types of securities continue to pay dividends at a fixed interest rate to investors until maturity. On maturity, the investors get back the principal, which is the amount they had initially invested, and the interest earned. Fixed Deposits (FD), National Pension Scheme (NPS), and Public Provident Fund (PPF) are some of the most popular fixed-income investments available to investors in India.
Fixed income provides portfolios with stability from market volatility as well as acts as a stable source of income where equity experiences wide swings in returns. Additionally, most fixed-income products have been incentivized by the government by offering tax benefits on investment. FDs and PPF are eligible for tax deductions up to Rs 1.5 lakh under Section 80C of the Income Tax Act, while NPS gives an additional benefit of Rs 50,000 under Section CCD.
Note that Fixed Income and Equity are together called the traditional asset classes. In fact, most portfolios can be adequately planned with just these two asset classes.
Gold (or other precious metals)
Gold holds cultural significance in Indian societies. While it has traditionally been a storehouse of value, it helps that gold is a limited resource and it does not depreciate with time. This makes the yellow metal an excellent hedge against inflation that tends to degrade value over time.
Additionally, gold has a low correlation with equities markets. When the equity markets tend to be on a downfall, like they did during the pandemic and economic turmoils before, gold prices have tended to remain stable. It may even outperform other economic classes due to its characteristic of absorbing economic shocks better. With its potential to store value amid uncertainty for its holders, gold can efficiently act as an investment cushion.
Gold may, therefore, be a good addition to investment portfolios in small quantities. Gold offers high liquidity, making it a favourable investment choice for most investors. Apart from physical gold, there are options such as Sovereign Gold Bonds, Gold Mutual Funds and Gold ETFs that one may explore for investment.
Plots of land, residential apartments, buildings, and property used for residential or commercial purposes– all come under this asset class. Owning your own home is considered a major milestone. However, it is quite an expensive asset class. The valuation is dependent on a lot of factors and it may come with a high maintenance and development cost too. Moreover, it is also affected by various political and economic factors, including many Government schemes.
Commodities are the asset class made of real (and not financial) assets. These include raw materials, food grains, petroleum, cotton, metals and more. Adding commodities to your portfolio provides the benefits of diversification. The prices are independent of stock market fluctuations, so it reduces the overall risk. Moreover, since these are real assets, their prices go up with inflation. In contrast, stocks perform better when inflation is in control. This creates a balance in the portfolio. Negative blows to stocks from inflationary pressures are softened with investments in commodities as an asset class.
NFTs and Cryptocurrency: The new-age asset classes
These asset classes have created a huge buzz over the past few years. Cryptocurrency is a decentralized digital currency that is traded over the internet. It is managed via blockchain technology and is not regulated by any central authority, such as the Government. Some of the popular cryptocurrencies include Bitcoin, Ethereum, and Dogecoin.
Non-Fungible Tokens (NFTs), on the other hand, can be understood as digital collectibles. It is proof of ownership of some specific digital content. The ownership of the NFT is recorded in a blockchain, usually the Ethereum blockchain. You can trace it back to the owner of an NFT as each NFT token is unique and cannot be replaced. The first NFT was sold back in 2017, when digital kittens, created by CryptoKitties, were sold. Some of the most popular NFT transactions have received immense media attention due to their amount. For example, the first tweet by the CEO of Twitter, Jack Dorsey, was sold for almost $3 million.
However, whether cryptocurrencies deserve asset class status, is still debated across the world. There are as many naysayers as there are supporters for this decentralized currency that is touted as the future of fiat currency. Investors who have a higher risk appetite and enough money to invest dabble in cryptocurrencies that have made millionaires overnight, as well as wiped out wealth at the same speed.
Now that you know what the various classes of assets are, let us see how they are allocated to balance your portfolio.
How does asset allocation work?
All asset classes have separate financial risks, with each of them having various factors that affect their performance in the market. As the asset classes hardly ever move in tandem with each other, asset allocation is a critical step to realize your financial goal.
Let us assume your financial risk profile analysis permits you to take risks with 60% of your portfolio. The fund manager would then allocate 60% of your funds to equity as an asset class and, keeping one part as liquid cash for emergencies, invest the remainder in fixed income securities for stability. As the matrix of your risk profile and responsibilities shift, so will your asset allocation.
Every investor usually has multiple financial goals to achieve within varying time frames. For example, you might aim to support the college education of your child and buy a home in the coming years. At the same time, you are looking to create a sufficient fund for your retirement years. Each of these goals has varying investment horizons and risk tolerances. You can take added risks for generating better yields for one while sticking to low-risk, conventional investments for the others. This is where asset allocation comes in. Allocating your money into different asset classes helps balance the chances of risks and benefits. This minimizes the overall risk in your investment portfolio while your portfolio also appreciates in value over time.
While investing, you need to keep these three aspects in mind:
1. Time horizon
This is the period in which you expect to achieve a particular financial goal. If investing for the long term, you might be able to create a riskier portfolio. This is because your investment will ride out the economic crisis and volatilities in the market with time.
2. Risk tolerance
This defines your readiness to lose some or most of your original investment in anticipation of greater potential returns. As various asset classes entail different risk exposures, it depends on your risk tolerance and whether you will take an aggressive or a conservative stance during asset allocation.
Assessing your risk profile is one of the most important aspects while investing. At the same time, you should also know how to measure and determine portfolio risk. Read all about it here in our blog!
Set your financial goal while investing. It will help you understand the required rates of return to achieve your predetermined target in a given period.
Strategy for asset allocation
While there are no set rules when it comes to investing, we advise you to keep these asset allocation tips in mind:
1. Tactical asset allocation
The flexibility of this strategy allows you to consider the market-timing component in your investment portfolio. It aims to maximise your short-term investment strategies.
For example, your current portfolio contains 15% cash, 35% equity shares, 30% bonds, and 20% commodities. After analysing the market, you foresee a rise in the price of commodities. To get the benefits of this upward trend, you may increase your investment in commodities from 20% to 25%, reducing your cash holdings to 10%.
Furthermore, tactical asset allocation can be done within a particular asset class. For instance, within the 35% equity shares you hold, 40% is invested in large-cap stocks, 30% in mid-cap, and 30% in small-cap stocks. If you see a short-term fall in the returns for small-cap stocks, you may adjust your holding. This can be done by reducing your small-cap investment to 20% and increasing your mid-cap stocks to 40%.
2. Age-based asset allocation
Using this strategy, you deduct your age from 100. The resultant figure helps to decide what percentage of your capital you should allocate for investment in equity. For instance, if you are 25 years old, you can invest 75% (100-25) of your funds in equities and the remaining 25% elsewhere. As you age, this percentage keeps going down. At 60 years of age, your portfolio must typically hold 40% equity only. This rule is mainly an outcome of your ability to withstand market fluctuations. At a younger age, you have more time to average out the losses you may incur.
3. Dynamic asset allocation
This strategy helps you determine what assets to purchase based on the market gains they show. It helps to constantly adjust the asset mix according to the fluctuations in the market. Financial critics deem this strategy as one of the most popular investment strategies.
4. Strategic asset allocation
This strategy encourages you to buy more of the asset class that is losing value. This is to ensure that the proportions do not deviate from more than 5% of the original mix. It is based on the buy-and-hold policy and is also known as constant weight asset allocation.
Asset allocation is an effective way to diversify your investment options by counterbalancing the risks and benefits. With asset allocation, you can take added risks for generating better yields for one asset class while sticking to low-risk investments for the others. Thus asset allocation helps you reach your financial goals without putting your investment portfolio at too much risk.
Asset allocation is not rocket science, but it can sound a little overwhelming for those getting started. So, how about an app that helps you to understand the complexities of the process of asset allocation? Teji Mandi’s app does exactly this by aiding investors with simple steps with asset allocation. Trusted by more than 10,000 investors, Teji Mandi is your one-stop-destination for simplifying all your investment hassles.