How Asset Allocation Impacts Your Portfolio
When investors create an investment portfolio, they consider several factors, like risk, asset class, inflation, etc., to generate optimal returns on their investments. However, what is equally critical when it comes to creating a portfolio is asset allocation and selection. Asset allocation aims to balance risk and reward through a portfolio composition of different kinds of assets. If not allocated efficiently, you may become subject to a slew of taxes and other charges. With efficient asset allocation, you can distribute your money across different investment instruments like stocks, bonds, T-bills, money market accounts, mutual funds, etc. As your portfolio is exposed to various markets, you can reap the benefits of these securities while effectively mitigating your risk. Consider consulting with a professional financial advisor who can advise you on optimal asset allocation and create a diversified investment portfolio suited to your financial needs.
Read more to learn about asset allocation and how it can impact your portfolio.
What is asset allocation?
Asset allocation is an investment strategy wherein risk and reward is balanced by adjusting a portfolio’s assets as per an individual’s risk appetite, financial goals, and investment horizon.
Markets are unpredictable by nature which is why you must look for optimum risk management. You can mitigate your risks through efficient asset allocation by investing in different asset classes rather than a single asset class. Remember the golden rule of investing – Never put all your eggs in one basket. While some investments promise great returns, they may carry a significant amount of risk. Thus, it is advised to not put all your money in one financial instrument. If you do so, the chances of losing money are comparatively more than gaining returns. If you are confused about how the asset allocation process works, you may also consider using an asset allocation calculator to pick your investments.
What is the difference between asset allocation and asset location?
While the terms asset allocation and asset location are used interchangeably, they are quite different. Asset allocation means selection of investments based on asset class, term period, sectors, etc., based on the investor’s goals, risk tolerance, and investment horizon. However, asset location refers to tax-minimization strategy wherein you invest in different kinds of investments to benefit from the different tax treatments meted out to the said investments.
What are the key asset classes?
An asset class represents securities that have some similarities. These classes are made up of smaller investments, and every class contributes differently to your portfolio. Stocks are the most popular asset class as they have high growth potential and can offer great returns both in the short and long run. However, they carry high risk as their performance solely depends on market movements.
You can invest in bonds to mitigate your risk. Bonds guarantee steady returns in both the long and short run. You should also invest in liquid assets, which can come in handy to meet your short-term expenses like mortgage payments, etc. When you allocate your assets in different asset classes, you safeguard yourself from market volatility. Also, you make your portfolio flexible and much more adaptable. Generally, investors get tied up in many investments, thereby hampering their liquidity. However, when you invest in various securities, you can liquidate some funds readily (like a money market account) if you need money in a pinch.
In that sense, asset allocation also helps decide your portfolio’s orientation. For instance, you can have an aggressive portfolio if you have a high-risk appetite and are inclined towards earning aggressive returns. For investors having a higher risk tolerance, more funds will be allocated to stocks in an aggressive portfolio. Similarly, a conservative portfolio will allocate higher funds to bonds, blue chip stocks, fixed-income securities, and more.
What is the impact of asset allocation on the portfolio?
Different factors come into play when you allocate your assets and create an investment portfolio. Let’s look at the impact asset allocation can have on your portfolio.
1. Portfolio proportion
The primary purpose of asset allocation is to limit risk and safeguard the investor from market fluctuations. For the same reason, the proportion of a portfolio is distributed among different asset classes like bonds, stock, cash equivalents, etc. You can also use asset allocation to decide the proportion of different investments within a particular asset class.
2. Risk-return tradeoff
Risk and returns are the most important aspects of any investment you make. There is always some tradeoff between risk and return when investing. Low-risk investments offer low returns whereas high-risk investments promise higher returns. Thus, at the time of allocating your assets, you must aim to balance your risks and returns. By doing so, you can minimize your losses on your investments.
3. Performance correlation
With efficient asset allocation, you can understand the correlation between the performance of two or more asset classes. While a few investments tend to lose or gain value in the long run, others move in opposite directions. Hence, asset allocation helps you enjoy the benefits of the performance correlations between two or more asset classes. When two or more investments move in the same direction, there is a positive correlation between the investments. For instance, bonds and high-dividend stocks have a positive correlation. However, there is a negative correlation between bonds and growth stocks. And so by using asset allocation, you can create a good mix of investments having both positive and negative correlation.
4. Portfolio structure
The impact of asset allocation on the portfolio is majorly driven by the investor’s risk tolerance and the duration for which the investments are held. Using asset allocation, an investor can structure their portfolio based on the current and predicted economic conditions. Once you allocate your assets, allow your portfolio some time to breathe. The investments may become more cohesive in the future and improve your earning potential.
How to decide on the best asset allocation
There is no standard framework for carrying out asset allocation as different investors have different needs. However, there are a few common pointers one can keep in mind before undertaking the process of asset allocation.
1. Your financial goals
Before you allocate assets and create a portfolio, you should try to understand your financial goals. For instance, if you want to fund your education expenses for the next three years, you would want to put your money in cash equivalents. You may want to avoid illiquid or risky investments, like stocks, in such a scenario. However, if growing your money is your primary objective, you may consider allocating a major chunk of your corpus to stocks and other equity investments.
2. Your age
Age is another crucial factor when it comes to asset allocation. For instance, if you are saving for retirement, investing in safer asset classes may be wise. However, if you start planning early, you can have a more aggressive asset allocation. Similarly, suppose you are investing money to build a corpus to fund your child’s education in the next 10 years. In that case, you can take an aggressive allocation approach where your portfolio can have more risky assets. Typically, you can be more aggressive in your younger years as compared to when you are nearing retirement.
3. Your risk appetite
Understand your risk capacity. It is arguably the most important factor to consider when allocating assets among different asset classes. If you are risk averse, you may want to stick to safer investments like bonds, government securities, fixed income securities, and more. However, if you have a high-risk tolerance, you can look to explore stocks, equity mutual funds, and such instruments.
Asset allocation is the process of designing your portfolio based on your needs and risk appetite. You must be mindful of your asset selection and financial goals for effective asset allocation. Before investing, try to understand every asset class and the risks they bring to the table. You can use an asset allocation calculator to invest efficiently. Also, if you are new to investing, you may consult a financial advisor.
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