Asset allocation refers to the procedure of striking a sound balance between your rewards and risk by opting for investments across distinct asset classes as per your financial goals, risk tolerance level, and investment timeframe. It plays an important role in financial planning and has a significant impact on your investment portfolio returns over the long term.
Here’s a guide to get started with asset allocation
- Set your financial goals before investing
Your asset allocation must be based on your investment goal, risk tolerance level, and the years left to attain those goals. Note that depending on the performance of the asset classes, you might need to rebalance your investment portfolio to stick to your initial asset allocation strategy to meet your goals of varying time horizons.
At the beginning of any financial year, ensure to get thorough clarity on your crucial goals before allocating investments towards them. In the case of long-term financial goals, invest in equity mutual funds as equity is the an asset class that has the potential to beat inflation and fixed-income asset returns by a wide margin over a long time period. For your short-term goals, invest in debt funds as they provide capital protection along with satisfactory returns. For mid-term goals, you may consider investing in hybrid mutual funds, which is a mix of both equity and debt instruments.
Note that, the key to generating a risk-adjusted return in your investment portfolio is by forming the correct asset allocation strategy.
- Avoid juggling your investments over the short term
The very temptation to shift your investments from one financial product to another depending on its short-term performance needs to be avoided. If you have invested your funds towards a financial instrument to attain your long-term goals, then its short-term performance must not bother you.
Juggling between investments tends to incur a cost and may prove to be fruitless in the long term. Instead, for your long-term investments, ensure to review their performance every year and if your investment constantly underperforms for over one to two years, then you should consider redeeming your investments and direct your money towards a better performing fund.
- Asset diversification can endow risk-adjusted returns
Asset classes tend to hold a negative correlation based on returns. A specific market condition might make an asset class endow higher gains while lowering the value of other asset classes. In such scenarios, diversification of your investments across different asset classes with negative correlation can help in counterbalancing the losses arising from correcting asset classes.
For instance, fixed-income assets and equities display a negative correlation. A slight economic fall or decline in corporate gains may negatively impact the equity market. As an outcome, the central bank might try to revive the economy by lowering policy rates to reduce the cost of borrowing, resulting in an appreciation in the prices of bonds. Thus, having both debt and equities in your investment portfolio may permit you to counterbalance your equity portfolio losses with capital appreciation in debt mutual funds. Likewise, equities and gold are also inversely correlated. When equity witnesses a fall owing to geopolitical or global uncertainties, gold investments tend to appreciate.
The future is extremely uncertain, and it might present a few surprises when it comes to finances. To manage fear and uncertainty, a robust and prudent asset allocation plan is a must. However, you may wonder how you can determine a specific asset allocation strategy as per your risk appetite.
It is very simple; you can use an asset allocation calculator. An asset allocation calculator is an instrument that instantly provides you with an appropriate asset allocation figure. You just need to input your present age, risk tolerance level (low, high, or medium), and investment timeframe. Depending on the choices you make, the asset allocation calculator will instantly form a profile and suggest you the ideal asset allocation strategy, for instance, 50% investment in equity and 50% investment in debt mutual funds.