What is Asset Allocation and How it Works?

One of the many fundamental strategies that investors use to achieve their financial goals and objectives is asset allocation. With the right asset allocation strategy, you can not only get to your goals much faster but also protect your investment capital from the negative impact of market downturns. Continue reading to get to know all about this concept and the importance of asset allocation. 

What is Asset Allocation?

Asset allocation is an investment management strategy that involves investing your capital across different asset classes like stocks, bonds, mutual funds and traditional investment options like bank deposits. The primary objective of asset allocation is to strike the right balance between risk and return for your investment goals, risk tolerance and horizon. 

Example of Asset Allocation 

Here’s a hypothetical scenario to help you understand how asset allocation works. Assume you’re a 32-year-old individual who wants to retire at 65 years of age. Your risk tolerance level is moderate and your investment horizon is 33 years. 

Since your investment horizon is quite long and your investment goal is to plan for retirement, you need to invest a significant portion of your capital in growth-oriented assets like equity stocks or mutual funds. Investing in equity assets for the long run can help you tide over short-term market fluctuations and create wealth. Going by your requirements and objectives, you could consider investing 60% of your investment capital in equity-related assets. 

However, seeing as your risk tolerance level is only moderate, you need to invest in low-risk, fixed-income securities like bonds. Doing so can help offset the high risk in equity investments and bring it down to a more moderate level. Furthermore, these securities can also provide you with a stable income stream to supplement your main source of income. Investing 30% of your investment capital in bonds and other debt securities should help you balance risk and reduce the impact of volatility on your portfolio. 

Liquidity and stability are two important aspects that you need to account for when allocating assets. Having liquid assets can act as a safety net for emergencies and short-term trading or investment opportunities. You need to invest at least 10% of your capital in cash equivalents like treasury bills, bank deposits and other money market instruments. 

To sum up, your asset allocation is as follows: 60% in equity, 30% in bonds and debt instruments and 10% in cash and cash equivalents.  

Note: This is a very simplified example of asset allocation. When you’re allocating assets, you may need to take into account a host of other factors and considerations.

Importance of Asset Allocation 

There are a plethora of different reasons why asset allocation is considered to be of paramount importance by investors and financial planners. Let’s look at a few reasons why. 

• Helps Manage Risk

Asset allocation helps with risk management by spreading your investments across multiple asset classes. This diversification can reduce the risk of your investment portfolio losing value due to the underperformance of one or two investments. 

• Optimises Returns

Asset allocation ensures the right balance between returns and risk based on your investment goals and risk tolerance. It prevents you from taking on too much risk in the pursuit of getting returns. 

• Align Investments With Your Financial Goals 

To ensure proper wealth creation, your investments must always be aligned with your financial goals and objectives. Asset allocation helps you achieve this by tailoring your investments in such a way that they help you get closer to your goals. 

• Ensures You Adapt to Changing Conditions 

The markets are ever-changing, and so is life. Asset allocation strategies, especially ones that are dynamic, adjust your asset mix as per the changing conditions. Whether the change is with your investment goal, risk tolerance or the broader market conditions the right asset allocation strategy can help you adapt quickly. 

• Prevents Impulsive Decision Making 

Asset allocation promotes financial discipline and keeps you on your path toward your goals by helping you avoid impulsive or panic-driven decisions caused by short-term market volatility, 

What are the Different Asset Allocation Strategies? 

Now that you’ve seen the importance of asset allocation, let’s quickly go through a few of the different strategies that investors commonly use. 

• Strategic Asset Allocation Strategy

The strategic asset allocation is a fixed strategy with a long-term outlook. It has a predetermined approach to the allocation of funds based on your financial goals, risk profile and investment horizon. 

• Tactical Asset Allocation Strategy

Tactical asset allocation allows you to make changes and modifications to your asset mix depending on the current market trend or economic conditions. Since the strategy has a short to medium-term focus and requires you to make changes on the fly, you may need to constantly monitor the markets. 

• Dynamic Asset Allocation Strategy 

This strategy combines the elements of both strategic asset allocation and tactical asset allocation techniques. It helps you maintain a long-term outlook while giving you the freedom to make changes and adjustments depending on how the market conditions change. 

What are the Key Factors You Should Consider When Allocating Assets? 

Before you begin the allocation of funds to various asset classes, there are a few factors you need to account for. Here’s a quick overview of some of the key considerations. 

• Investment Goals 

Your investment goals should determine your asset allocation strategy. For instance, if your goal is to plan for retirement, you could adopt a strategic allocation strategy. On the other hand, if your goal is to capitalise on short to medium-term price movements, adopting a tactical asset allocation strategy may be a more appropriate choice. 

• Risk Tolerance

Your ability to withstand market risk is another major factor that influences the allocation of funds. If you have a high tolerance for risk, you could consider allocating a significant portion of your investment capital towards equity. However, if your risk tolerance is low, you may need to allocate a majority of your capital towards safer and less risky assets. 

• Age and Investment Horizon

Your age also dictates the kind of assets you can invest in to reach your financial goals. For example, if you’re young and have a long time till retirement, you can afford to invest in growth-oriented assets despite their risky nature. However, if you’re older and have only a few years until retirement, you may need to shift your focus from risky assets to more stable, fixed-income securities. 

• Income and Expenses

Allocation of funds towards asset classes also depends on your income and expenses. Your income level also determines just how quickly you can reach your goals. For instance, if you have more disposable income, you can consider increasing your equity investments. This may help you accumulate wealth much faster. 

Conclusion 

To put it simply, asset allocation is a fundamental investment strategy that can help you manage risk and optimise returns. Irrespective of the type of asset allocation strategy you choose, it is essential to periodically review it and make adjustments to adapt to the ever-changing market and economic conditions. 

Open a Demat Account with Angel One and explore various investment options like stocks, SIPs, mutual funds, etc. 

FAQs