As an investor you have probably been advised time and time again to diversify your investment. The often-repeated statement – ‘Do not put all your eggs in one basket’ probably rings a bell. While diversification implies not putting all your money into one type of fund or one type of stock, what about diversification across asset classes?
Have you considered the importance of asset allocation? Before you consider diversification, the first step to investment success – is achieving an optimum asset allocation.
What is asset allocation?
Asset allocation is essentially obtaining the correct mix of asset classes in your investment portfolio to balance risk and reward and achieve your investment goals.
There are a wide variety of investments options available today, ranging from fixed deposits, government bonds, and corporate bonds to direct equity and various types of mutual funds.
To illustrate, if you have an investment corpus of INR 10 lacs, asset allocation means spreading this amount amongst different investment types. The % allocation of each investment type in your portfolio depends on your investment goals and your risk appetite.
Why asset allocation?
So why is it important to focus on asset allocation?
Every investment class has a different risk and reward profile
Every investment category is subject to different level of risk and has potential for a different reward level. For e.g.: a fixed deposit investment has limited risk as it is backed by the bank, but it has limited potential for return, limited to its interest rate. On the other hand, equity investment has higher risk potential as it is dependent on market forces, but it also has higher return potential as it is not restricted by any interest rate.
Investors’ have multiple goals
Every investor has multiple financial goals, ranging from short term goals to long term goals. The financial goals and financial health determine the risk appetite of the investor. All goals are unlikely to be suitably funded by a single investment type - different goals can be funded through different types of investments.
For eg: short term goals can be funded through fixed income funds whereas long term goals can be funded through market driven funds which are likely to give higher returns over a long period.
Risk minimisation and reward maximisation
Along with allocating investments according to the investors’ goals, the other fundamental goal of investment planning is to maximise reward within an accepted risk level. Diversifying investments across different asset classes can be used to achieve this. It reduces dependency on a single type of investment.
Preparation for emergencies
Optimum asset allocation can help you with the necessary liquidity needed for emergencies by allocating a portion of the investment corpus in low risk and highly liquid investments.
Consistency of returns
A mix of low return and high return investments can help achieve consistency in returns over time.
All in all, focussing on optimum asset allocation can help an investor achieve his multiple investment goals while maintaining risk levels within an acceptable threshold.
So how can an investor determine his asset allocation? It may be wise to seek professional help of portfolio managers. These professionals are experts in the field of investment management and can help the investor find the best mix that suits his investment goal.
It is also important to remember that asset allocation is not a onetime exercise and cannot remain constant during the investor’s investment tenure. It’s important to constantly review your asset allocation and rebalance it to align with the changing markets and changing investment goals.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.