Wealth management forms the most important aspect of financial planning and can add value to an investment plan if executed rightly. Many of us will invest in fixed deposits and bonds viewing fixed income securities as more conservative investments. However, during period of rising interest rates, they can damage the total return if one does not have a defined strategy within their investment policy. Here asset allocation and diversification play an important role. In today's environment of volatility in stock markets, high inflation rate and increasing investment avenues, it becomes furthermore necessary for investors to choose the asset class in such a way that it can provide superior returns and reduce the overall portfolio risk.
Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance and investment horizon. In simple words, it is the task of figuring out how much of one's portfolio will be invested in each of several different "asset classes" depending on one's risk taking ability and financial goals. There are three main asset classes viz. equities, fixed-income (debt) and cash and equivalents. Each asset class has different levels of risk and return, so each will behave differently over time. Studies have shown that proper asset allocation is more important to long term returns and most of the portfolio returns depend upon the asset class rather than specific individual investments.
This is best explained by the fact that though equities are tried and tested to perform best among most asset classes over the long run, an investor having only equities in his portfolio in 2008 (global financial crisis led by US sub-prime issue) could have suffered the most despite diversification across stocks, as equity markets were 50% down in 2008. Whilst fixed income instruments likes bonds, fixed deposits (FDs), or even cash or its equivalent are considered safer options, the returns from this class are limited, which could be a dampener in the times of high inflation. For example an 8.8% yielding bond in current times of over 9.08% inflation rate (for primary articles) would be giving a negative real returns (inflation adjusted returns) of 0.28% (8.8%-9.08%).
A traditional investment portfolio generally comprises of a combination of the above mentioned investment vehicles i.e. equity, debt and cash and equivalent. However, an optimal portfolio may also contain exposure to alternative, nontraditional asset classes such as real estate, gold, commodity, etc. to provide incremental returns vis-Ã -vis the additional risk in these segments.
Why asset allocation?
The right asset allocation helps to counter market uncertainty as it diversifies the investments not only within an asset class but also across asset classes. The main advantage of having different assets in the portfolio is that a decline in any one asset can be offset to an extent with the presence of other assets, which are not witnessing the same trend (in this case a decline). The reason that justifies this strategy of asset allocation is the notion that different asset classes offer returns that are not perfectly correlated. Hence diversification reduces the overall risk of the portfolio. For instance, inflation which can be a negative for stocks in the short-term, could actually lead to a rise in gold prices (as investors move from currency denominated assets to 'real' assets). By including asset categories that move up and down under different market conditions within a portfolio, an investor can protect against significant losses.
The right asset allocation also induces investment discipline and helps not to get carried away by the market sentiments. For example, the overall equity portfolio can go much above the proposed asset allocation when the stock market is rising or can fall well below the proposed asset allocation when the market turns bearish, however risk appetite remains the same. Here a regular "re-balancing" helps investors to book profit when the stock market is high and re-invest the same amount when the market comes down.
How to determine the right asset allocation
Investors should however understand that there is no simple formula that can find the right asset allocation for all. An investor's asset allocation depends on a range of personal factors which includes risk tolerance, time horizon, financial situation, age, income, cash inflows and outflows, the number of dependents, among others. Depending on the above parameters, an investor is profiled as conservative, aggressive or moderate. Here are the examples that show the sample asset allocation for aggressive and conservative investors. A young and aggressive investor emphasizes on growth and has a long investment time frame. Thus, he will have more allocation to riskier assets like stocks, equity funds, gold etc (say 70%) while the rest would be distributed among debt and money market instruments. On the other hand, a conservative investor will have lower exposure of say 10-30% to stocks, equity funds and higher allocation towards debt and money market instruments to safeguard the investment corpus. This is meant for people who are very risk averse or who are retired or nearing retirement. The moderate investor seeks to strike a balance between growth and stability.
The strategy of asset allocation is purely for planned investments and intends to make one aware of his financial goals and invest wisely. It provides a good beginning to a new investor (if done systematically and with due diligence) in achieving his financial objectives by optimizing risk and returns through asset class diversification.
The article on' Importance of Asset Allocation' has been prepared by SBI Funds Management (P) Ltd, the Asset Management Company of SBI Mutual Fund for the purpose of investor education only. SBI Funds Management Pvt Ltd. / SBI Mutual Fund / Trustees, its directors and employees will not in any way be responsible for the contents of these articles. This is not an offer to sell or a solicitation/ recommendation to buy any securities. Investors must make their own investment decision based on their own investment objectives, goals and financial position and based on their own analysis and consult their financial advisors / consultants before taking any decision of investments.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.