Asset Allocation is the biggest determinant of portfolio success. As per a study, 92% of the returns in a portfolio can be attributed to asset allocation.
It deserves the most of your time and attention in investment management.
Figure out your risk profile and time horizon based on your goals and then select an asset allocation.
The idea of asset allocation is rooted in the fact that by using assets that are uncorrelated and behave differently in different cycles, you can reduce the overall variability and risk of losing the capital.
What are the various asset types you can use?
- Assets can be market linked such as mutual funds or stocks or they can be non market-linked such as, your Bank FDs or Corporate Bonds.
- They can be liquid or illiquid, that is how soon can you turn your asset into cash. For real estate, not so easy. For a listed stock or bond, matter of hours or a day.
- They can offering a fixed return with no price appreciation (most fixed income investments) or a variable return with price appreciation (stocks, gold, etc.).
Fixed Income investments offer a consistent return experience and have a little or no element of risk. Your investment or capital is safe and returns are assured.
This includes your Bank deposits, Provident Fund, Government sponsored schemes such as Sukanya Samriddhi Yojana and PPF and other post office schemes.
Equity includes stocks and shares representing ownership in business / enterprises, listed on a stock exchange or unlisted (to be privately bought and sold).
As mentioned, there is no guarantee of your investment let alone any returns. If they are listed / traded on an exchange, the daily prices can fluctuate a lot and show a notional loss too.
You buy equity because you wish to benefit from a growth of an enterprise thus resulting in dividends or an increase in value of your investment.
Gold is a valuable metal which acts as a store of value or insurance for volatile times. Till today, it is treated as a currency without borders, It may not yield a return but in really bad times, you can expect to use gold in exchange for food.
Real Estate and Alternative Investments do also exist as asset classes. You may choose to include them as part of your portfolio.
Making a strategic asset allocation
This is your top level asset allocation determined on the basis of your risk profile and investment time horizon.
Taking the analogy of a journey on a ship, the ship is the portfolio, the strategic asset allocation is your map.
To succeed with investing, you have to pick your own asset allocation. Invest as per the allocation that fits your profile and then rebalance on a yearly basis.
ASSET ALLOCATION MODELS
Here is an asset allocation matrix using 3 asset types – Fixed Income, Equity and Gold.
Every investor is unique and so can be his/her portfolio asset allocation.
Your asset allocation can work on the tethering concept. As long as you are pegged to a number, it is okay to move around a bit, without crossing the barrier. Call it a tolerance limit.
You can opt for a fixed %age for yourself and then define a tolerance limit.
For example, as a moderate investor, you can choose to invest 60% in equity. That’s your number to watch. You can then define a 10% tolerance limit. As long as the allocation stays between 50% to 70%, you may not want to take any action.
Fixed Income – Asset Allocation
Within fixed income, there are several options available primarily divided by credit risk (chances of getting the money back) and time horizon.
The following matrix helps you with ideas on what all can you consider for your fixed income allocation, based on risk profile and time horizon.
Note: You may choose to buy directly such as Bank FD, Government Bond, Corporate Bond / NCD or a PPF account.
Those in the highest tax bracket can benefit from tax efficiency of debt funds.
The specific instruments will come up later.
For most investors, funds falling under liquid, ultra short and low duration funds will suffice for their fixed income allocation.
Equity – Asset allocation
Within equity, large, mid and small cap are the primary sub classification with respect to risk and available exposure.
Note: Equity investment can be done through direct stocks or equity mutual funds.
Comprehensive Strategic Asset Allocation
We put all this together now into a strategic allocation based on each risk profile and time horizon.
Click on the respective link to view the full allocation.
Tactical Asset Allocation
Since we have covered strategic asset allocation, the tactical asset allocation deserves a mention. Here’s a note for your reading.