Asset allocation is an important tool for investors. It helps in reducing risk while growing your investments. It also helps in designing the portfolio based on your needs and goals as an investor. It is important because it aligns investments with an individual’s goals. Besides, it also instils the habit of financial discipline in them.
How does Asset Allocation work?
Asset allocation aids in designing a portfolio by taking into account certain factors. Some of the factors include the client’s income, goals, needs, and life duties and responsibilities. Age is an important factor while designing the portfolio. It reduces the investment horizon and risk-taking ability of an individual. For example, a retired individual is likely to have a higher need for a fixed income. They are less likely to be in a position to digest the volatility of risky stock market investments. They are also more likely to have a higher need for safety and security. Hence, their portfolio could need higher allocation towards debt instruments and real estate. A small part of the portfolio could be allocated to volatile assets such as gold and equity. Young individuals have a longer investment horizon and a high risk-taking potential. As a result, equity is an ideal class of investment for them to generate long-term capital.
Types of Investors
While allocating assets, the risk tolerance level of an individual needs to be assessed. Aggressive, moderate, and conservative are the three types of investors. An aggressive investor will demand higher growth and he/she will be willing to take higher risk for that. A conservative investor would rather prefer safety and prefer certainty over volatility. A moderate investor will take calculated risks and prefer to grow at a moderate pace, maintaining the balance between risk and growth.
Asset Allocation Based on Investor’s Profile After assessing the type of investor, his/her investments are categorized into two categories:
1) Strategic rebalancing and
2) Tactical rebalancing Strategic rebalancing focuses on long-term goals, more suitable to moderate and conservative investors. This is a passive approach that believes in the ‘Buy and Hold’ strategy. Portfolio churning is less frequent. It is only done when an investment fails to generate desired returns over a certain period.
Tactical allocation is an active style of investing, more suitable for aggressive investors. The aim here is to divide a certain part of the portfolio to invest in short-term opportunities. With this style, the investor intends to use the opportunities that emerge out of the volatility, a shift in business, or economic dynamics. This is a high-risk, high-gain approach that requires investors to be more vigilant. It is more suitable for investors with more years of experience.
The goals and risk tolerance levels of investors keep changing as they move on in their life cycle. It could be a change in goals, risk tolerance, and income profile of the investors. Their portfolio needs constant change to keep up with these changes. And, asset allocation is a crucial tool to achieve that balance.