It is often said that asset allocation is the cornerstone of financial planning. However, investors often tend to overlook the aspect of asset allocation. So, what is asset allocation? Asset allocation is the strategic distribution of an investment portfolio among different asset classes, such as stocks, bonds, commodities, REITs, InvITs etc. Asset allocation aims to optimize risk and return by diversifying investments based on factors like financial goals, risk tolerance, and time horizon.
Asset Classes Available
1) Equity: Equities have the potential to generate relatively better return among the various asset classes. However, what one needs to be mindful about is that the asset class is perceived to be risky or aggressive because of its volatile nature and its ability to display sharp movements. The volatility in the stock market introduces the possibility of substantial losses alongside significant gains.
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2) Debt: Fixed-income investments, such as bonds, are typically viewed as safer or more conservative than stocks. While bonds offer a steady income through interest payments and the return of principal at maturity, they historically yield lower rates of return compared to stocks.
3) Commodities: Today investors have the option to invest in gold and silver. Gold is known as a hedge against inflation and protects the portfolio from volatility in other asset classes. Overall, it offers liquidity and stability, thereby serving as a means to preserve capital.
4) REITs & InvITs: Real Estate Investment Trusts and Infrastructure Investment Trusts are instruments providing exposure to real estate without actually owing physical property. These instruments are used by fund managers as return enhancing mechanisms.
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Why asset allocation matters for investors?
1) Diversification: Asset allocation ensures the portfolio remains well diversified over different asset classes at all points in time.
2) Risk Management: It helps spread risk across different asset classes, thereby reducing the impact of poor performance in any single investment on the overall portfolio.
3) Return Optimization: Proper asset allocation can boost the potential for returns balancing the pursuit of growth with the need for stability.
4) Long-Term Planning: It aligns investment strategy with financial goals and time horizon, providing a framework for achieving objectives over the long term.
5) Adaptability: As financial goals or market conditions change, adjusting asset allocation allows investors to stay aligned with their objectives and respond to market dynamics.
Types of Asset Allocation Strategies
1) Strategic Asset Allocation: This is a long-term investment strategy that involves setting up a predetermined mix of asset classes based on an investor's financial goals, risk tolerance, and time horizon.
2) Tactical Asset Allocation: The allocation strategy involves making short to medium-term adjustments to the asset mix based on several factors such as current market conditions, and economic outlook, among others.
3) Dynamic Asset Allocation: As the name suggests, the allocation to various asset classes changes in a dynamic manner in response to the changing market conditions. Such dynamic management is possible at the mutual fund, fund manager level who closely track the market on a day-to-day basis.
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Asset Allocation based Mutual Funds
Mutual funds offer a convenient way to implement asset allocation, especially through categories such as the multi-asset fund. This category of mutual funds offers investors exposure to various asset classes within a single fund.
According to the SEBI definition, multi-asset allocation funds are mandated to allocate a minimum of 10% to at least three different asset classes. Consequently, the majority of these funds provide investors with a diversified portfolio spanning equity, debt, and commodities. Some fund houses go further by including overseas securities, REITs, and InvITs as components of the fund.
Why choose these funds?
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Mutual funds through the multi-asset category offer diversification by investing across various asset classes, minimizing risk, and enhancing portfolio stability. Managed by professionals, these funds provide simplicity, automatic rebalancing, and effective risk management, through their diverse investments.
Moreover, multi-asset allocation funds are taxed similarly to equity funds, making it a tax efficient option to take exposure to multiple asset classes. Given the nature of the fund, investors can consider lumpsum investment as well in this category offering. Those looking to make a staggered investment can consider the SIP route.
