What is the importance of Asset Allocation?
Asset allocation is a simple concept which means allocating your investments across various asset classes so that the poor performance of any one asset does not affect the overall performance of the entire portfolio.
Different asset classes are differently correlated with one another. For example, when equity does well, debt or gold may not do well, and vice versa. It is this different correlation that makes asset allocation such a critical component of financial planning.
Asset Allocation depends upon the following factors:
- Your risk profile (appetite and tolerance)
- Your financial goal time horizon
Usually, determining the right asset allocation for you is best done by your personal financial planner.
Consider two persons: Mr. Kautav and Mr. Anand.
Mr. Kaustav is a 30 year old male who is married and has no children. He wishes to plan for his retirement, and so his goal time horizon is 25 to 30 years.
Mr. Anand on the other hand is 45 years old, married and with a 10 year old child. His goals include buying a house i.e. accumulating a down payment in 5 years, sending his son to college in 8 years, and planning for his own retirement in 15 years.
Asset Allocation for Mr. Kaustav and Mr. Anand is given as follows:
Mr Kaustav already has his own house and hence his allocation to real estate is simply the value of his own home.
Mr. Anand is buying a home for which he is accumulating down-payment funds. When he purchases the home he will be buying real estate and hence adding real estate to his asset classes. He has a lower exposure to equity due to the higher number of goals, their comparative nearness in terms of years, and his higher age which reduces his risk appetite and tolerance.
Mr. Kaustav on the other hand has higher exposure to equity, a riskier investment, because his only goal is retirement, and the time horizon of the goal is 25 to 30 years i.e. long term.
Remember, asset allocation is not a one-time process. It is not static, but dynamic. As your goal draws nearer, it is important to reassess your asset allocation and withdraw from risky investments – to de-risk your goal’s portfolio.
You can decide what your asset allocation should be for each of your goals. Here are some guidelines you can follow in deciding asset allocation:
- If your goal is more than 10 years away, you can invest up to 70 – 75% of your investible funds into equity, depending on your risk profile. The remainder of your investment can be put into debt (15 to 20%) and gold ETFs (around 10%).
- As your goal comes closer, for example when your goal is 6 years away, you can maintain an asset allocation of 60% in equity, 30% in debt and 10% in gold ETFs.
- When your goal is less than 3 years away, it would be wise to not expose the corpus to equity market volatility. Maintain a 100% exposure to fixed income instruments.
Remember, those investors who were invested in equity when the markets crashed in 2008 and in early 2018, and had a goal such as their child’s education or their own retirement less than 3 years away, have had to watch their goal funds get eaten away in the market crash. They also may not have had enough time to rebuild their goal corpus. This is why it is absolutely essential to de-risk your goal portfolio as your goal draws nearer.