We often receive advice from doctors or dietitians to maintain a balanced diet, including protein, carbs, vitamins, etc., because each nutrient plays a different role in the body. For instance, protein aids muscle repair and growth, especially crucial for physically active individuals or those engaged in strength training. The same idea applies to investing money. To make our money grow, we need to spread it out across different types of investments, like stocks, bonds, commodities, real estate etc. Each investment type helps our money grow in its own way. Just like we need a mix of foods for a healthy body, we need a mix of investments for a healthy investment portfolio.
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Typically, individuals primarily consider the potential returns before making any investment. This often makes them concentrate only on equities. Some investors perceive all investments as carrying similar risks to equities, so they stick to physical options like real estate and gold. However, both these approaches are extreme and hence striking the right balance is very important. By spreading your investments across different types, or "asset classes," you can build a balanced investment mix. This approach enables an investor to have a good investment experience while also keeping risks under control.
Why Asset Allocation is Important?
Risk and return go hand in hand, but risk is a double-edged sword. By spreading investments across asset classes, risk can be addressed effectively, as no two asset classes react to a market or economic development in a similar manner. Given this, the return profile of asset classes also varies, hence allowing overall optimisation of the portfolio. For instance, during turbulent years like 2008 and 2011, the S&P BSE 500 experienced significant negative returns of -52.3% and -24.6%, respectively. Investors heavily invested in equities and faced substantial drawdowns. Retail investors often panic during market downturns, leading to selling at losses due to fear of further erosion of capital. However, a portfolio balanced with both equities and debt would have experienced lesser drawdowns, such as -22% in 2008 and -8.8% in 2011, considering debt returns at 7%.
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Moreover, asset allocation aligns with an investor's time horizon and risk profile, catering to both short-term and long-term needs. A balanced mix of equities, debt, and cash is essential for meeting these objectives. Additionally, tax implications too vary based on asset class. For example, long-term capital gains tax on equities is 10%, whereas debt is taxed according to marginal rate.
Right Approach to Asset Allocation
The initial step in determining how to invest your money involves assessing your comfort level with risk. This relies on factors such as age, the size of your family, and financial commitments. Consulting a financial advisor can aid in gaining clarity on your risk tolerance by asking targeted questions. Once you understand your risk tolerance, it is vital to take into account your financial objectives and obligations. This assists in identifying the necessary investment returns. Subsequently, you can allocate your funds across various investment categories.
Simply determining asset allocation is not sufficient. Investors must also carefully evaluate other parameters at the asset class level before investing. Firstly, they should assess the accessibility of selected asset classes, considering how easy it is to buy or sell investments. For example, while stocks and mutual funds offer straightforward accessibility, real estate can be more complex. Additionally, investors should factor in associated costs, such as fees and commissions, as higher expenses can directly affect overall returns. Liquidity is another crucial consideration, determining the speed at which investments can be converted into cash. By thoroughly examining these factors, investors can make more informed decisions and optimize their investment strategy for long-term success.
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Although each person's circumstances vary, asset allocation is a fundamental principle that offers a foundation for making investment choices. For further insight into asset allocation, individuals seek advice from financial professionals who can help identify the most suitable asset allocation strategy. There is also an option of opting for multi-asset allocation funds, which can help investors achieve the objective of a diversified portfolio. This type of fund is mandated to invest across three or more different asset classes.
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