Financial planning is the process of defining different financial goals, quantifying these goals, factoring in inflation and having an investment plan to meet these goals. A financial plan acts as a guide for your future and helps you be in control of your earnings, expenditure and savings.
The Role of Asset Allocation
When you commence the process of financial planning, you start off with your goals in mind and then work backwards and chalk out a plan to achieve these goals. Investors should allocate their funds based on their risk appetite, goals and investment horizon. Helping you achieve just this is a prudent asset allocation strategy. Asset Allocation helps strike a balance between risks and growth while fulfilling long-term financial goals. It helps an investor get the benefit of more than one asset class while ensuring concentration risk is at bay.
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Every asset class behaves differently in different economic conditions. But every asset class serves a unique purpose in the portfolio as well. For example, equities bring the growth element while debt investments would offer stability to your portfolio. Add to this a commodity like gold, they provide a hedge against inflation. Overall, a portfolio with all of these asset classes will ensure that risk and return is optimally balanced while aiming to secure optimal returns.
Challenges Faced
An important to aspect to remember here is that asset allocation is not static in nature. As an investor moves through various life phases, the risk tolerance also changes and the same will be reflective in asset allocation as well. If one is unsure how to go about all these, then they can use the aid of an asset allocation mutual fund. The other option is to consult a financial advisor who will help put together your asset allocation strategy and guide you through it.
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A sound financial planning and asset allocation involves an element of rebalancing the portfolio as and when required. For example: If the target asset allocation is 50% equity and 50% debt, then a sharp equity market rally can distort the allocation to 70% equity and 30% debt. This drastically alters the risk profile of the portfolio. Hence, it becomes imperative to book profits in equities and allocate more to debt such that the proportion is more or less maintained and consequently the risk profile is maintained at all times. But this activity involves tax incidence. As a result of all these complications, investors often tend to forego on rebalancing.
Another challenge faced comes in the form of emotions – greed and fear. In a raging equity market, investors forgo rebalancing in the hope of reaping higher profits. On the other hand, if there is a market correction, owing to fear investors shy away from deploying further thinking of the potential losses. As a result, human behavior tends to be a deterrent to prudent asset allocation.
Asset Allocation Funds
To avoid these hassles, investors can consider investing through asset allocation schemes. Here, basis one’s requirement, an investor can choose a balanced advantage category fund wherein the portfolio will have two asset classes – equity and debt or a multi-asset fund wherein the portfolio will have three or more asset classes; the most common being equity, debt and gold.
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In a balanced advantage scheme, the asset allocation between the two asset classes - equity and debt - is quite dynamic and changes basis the prevailing market conditions. As a result, such a fund has the flexibility to manoeuvre volatile market conditions better by buying stocks when they are available at relatively cheaper valuation and selling them at higher valuation as the market rises. As a result of this arrangement, the returns generated tend to much more stable than an equity fund. Also, the approach is agnostic to emotions and this form of rebalancing is tax efficient as well given that the investor does not attract taxes when rebalancing in a fund.
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In effect, by investing in a dynamically managed asset allocation scheme, one can be rest assured that the fund manager basis the market conditions will allocate across asset classes. Such an offering provides a huge boost in the larger financial planning as well.
