Why is asset allocation important in investment? Here are 6 reasons

The importance of asset allocation is to create a balanced portfolio that reduces risk, maximises returns and helps manage investors behaviour.

CA Rohit J. Gyanchandani, MintGenie Team
First Published17 Apr 2023, 03:13 PM IST
 Aditya Birla Sun Life Multi Asset Allocation Fund
Aditya Birla Sun Life Multi Asset Allocation Fund

Investing is an art and creating a balance between various asset classes in order to increase returns and reduce risk is the ultimate goal for portfolio management. There have been periods where equities have done well, there have also been periods where gold or debt investments have done better than equities. Goal of an investor should be to create a proper mix of these assets to ensure the volatility is reduced and reasonable returns are generated in the longer term.

Asset allocation is a crucial component of investment strategy that involves dividing an investment portfolio among different asset categories, such as stocks, bonds, real estate, and cash, in order to achieve specific investment objectives.

Diversification is the basic premise of asset allocation as investable asset classes are decided based on goals and risks, and the need to mitigate portfolio volatility. The main goal of asset allocation is to minimise volatility and maximise returns. The process involves assessing your risk/return profile and then investing money in a certain proportion in asset categories that do not all respond to the same market forces, in the same way, at the same time.

Asset allocation also varies depending on the age and risk appetite of the investor, for eg: an aggressive investor might like to allocate 70% in equities, 20% debt and 10% gold. However, a conservative investor might want 50% in equities, 30% debt and 20% gold.

Let us understand the importance of asset allocation:

Managing risk: Asset allocation helps to manage investment risk by spreading investments across different asset classes. This diversification can help to reduce the impact of market volatility and protect against significant losses in any one particular asset class. In the current market scenario where the interest rates are elevated along with higher inflation, debt mutual funds along with allocation to gold would tend to do better than equities.

Balancing needs and goals: Asset allocation allows investors to balance their investment needs and goals by taking into account their risk tolerance, investment horizon, and financial objectives. This enables investors to invest in a mix of assets that meet their specific needs and goals.

Flexibility: Asset allocation provides investors with the flexibility to adjust their investment portfolios as market conditions change or as their investment goals evolve. This allows investors to adapt to changing market conditions and ensure that their portfolios remain aligned with their investment objectives. Having a certain portion of your investment in debt mutual funds could be used to deploy in equities when the markets have significantly corrected & also vice-versa.

Maximising returns: Asset allocation can help to maximise returns by investing in a mix of assets that have different risk and return characteristics. By allocating assets in a way that matches investment goals, investors can potentially earn higher returns for a given level of risk. According to a study published by Financial Analysts Journal in 2005, 91.5% of the investment returns are attributable to proper asset allocation in the portfolio.

Managing investors behaviour: Irrational behaviour is very common in investing due to greed and fear that plays a big role in how we invest. When the market is high, people put more money in stocks expecting the market to go even higher. When the market is low, people sell stocks fearing the market to go even lower. Such irrational actions harm the long term financial interests of the investors. An asset allocation based approach takes emotions out of investing and keeps you disciplined.

Winners keep changing: As mentioned earlier, in the past, different asset classes have outperformed/underperformed each other in different stages of investment cycles. Asset allocation may ensure a degree of portfolio stability in different market conditions and may give good returns across investment cycles.

Factors to be considered in order to define the allocation towards various asset classes:

Time horizon: This is an important factor in determining the allocation towards risky asset classes like equities. Lower time horizon would mean lower allocation towards equities and also lower possible returns on the investments.

Risk tolerance: This refers to an investor's ability & willingness to see volatility in his portfolio during adverse market conditions. Aggressive investors, or investors with a high risk profile are likely to risk most of their investments to get better returns. On the other hand, conservative investors, or risk-averse investors are likely to invest in securities that preserve their original investments.

TIP: Asset allocation is an important and difficult task. It requires specific knowledge about markets and various asset classes. It is suggested to take assistance from an advisor who is full time into the profession of wealth management as they are equipped with better data and information to make informed decisions about making movements between different asset classes at different times. Their experience can be used to ensure a smoother investment experience.

Rohit Gyanchandani is Managing Director at Nandi Nivesh Private Limited


 

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Rebalancing of portfolio comprises changing the weightage of assets in portfolio.
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First Published:17 Apr 2023, 03:13 PM IST
HomeMoneyPersonal FinanceWhy is asset allocation important in investment? Here are 6 reasons

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