As described by Robert Kiyosaki in his book “Rich dad Poor dad” asset is something that puts money into your pocket. Asset allocation refers to the process of dividing your investible income amongst different asset categories such as stocks, bonds, debt, gold, cash and cash equivalents etc. It helps investors to diversify their portfolio and balance the risk and rewards by adjusting percentage of amount invested in different asset classes.
Asset allocation is based on the principle that different assets perform differently in different market and economic conditions. It is difficult to predict how a particular asset will perform in the market, so it is advisable to invest in multiple asset classes such as debt, equity, gold, cash, etc. to balance overall risk and returns. If a particular asset underperforms, you get returns from other assets which perform better. Asset allocation works best when assets have a weak correlation.
Let’s illustrate with an example to understand the impact of asset allocation on the overall portfolio
Suppose Rahul and Ruhi have free cash of Rs 200,000 with them.
Rahul decides to invest Rs 1,60,000 in equity and keeps the remaining Rs 40,000 as cash with himself whereas Ruhi invests Rs. 1,00,000 in equity, Rs. 60,000 in gold, Rs. 40,000 in debt.
Rahul and Ruhi suffered a loss due to the equity market crash.
Ruhi having a diversified portfolio recovered loss occurring from equity with the help of income from other assets- debt and gold whereas Rahul had no such option.
Hence, it is advisable to never put your eggs in one basket.
There is no full proof formula for the right asset allocation, it varies from individual to individual. Some factors which should be considered while choosing the right asset allocation are:
Time- It refers to the time period for which the investor wants to invest his/her money.
Investment goals- These refer to the financial goals of an individual. Each and every individual has different financial goals.
Risk profile- It is made up of three components
Risk capacity- Ability of an individual to take a risk
Risk appetite- Willingness of an individual to take a risk
Risk tolerance- The emotional capacity of an individual to handle risk
All these factors play a vital role in choosing the right asset allocation.
REBALANCING OF ASSET ALLOCATION
The value of asset allocation changes with time due to market conditions so in order to maintain the desired ratio of different asset classes, rebalancing is done. It helps an investor to maintain his original allocation strategy. Over a period of time asset allocation changes due to market performance. Imbalancing may increase or decrease the risk and returns from a portfolio.
A person’s initial portfolio:-
Portfolio after 3 years:-
As depicted in the charts above, the original ratio of investors’ asset allocation changes to 53/29/18 at the end of the year from 50/30/20 due to changes in market conditions. Therefore the investor needs to rebalance his asset allocation at the end of the year.
Rebalancing can be done in the following ways:
You can sell the overweighted assets and buy the underweighted ones.
You can invest additional money in under weighted assets.
If you are making continuous contributions to the portfolio, you can alter your contributions so that more investments go to under-weighted asset categories until your portfolio is back in balance.
The frequency of rebalancing depends on investors’ goals, risk tolerance, and financial needs. Rebalancing can keep an investor’s portfolio aligned with risk tolerance and expected return.
Conclusion:
Our body needs a balanced diet in the same way our financial health needs balanced risks. Asset allocation is the most important aspect of portfolio construction. The right mix of assets can maximize returns and minimize risks in the long run. One should neither over-diversify nor over-concentrate amongst asset classes and hence should also regularly review their portfolio and take corrective actions.
REFERENCES:
ABOUT THE AUTHOR
Bakshish Kaur
Bakshish is an extremely hard-working girl. She is always enthusiastic about Finance. She is self-motivated, reliable, responsible, and a keen learner. She is friendly, helpful, and has a good sense of humor.
Insightful