Last Updated on January 23, 2024 by ethinos
Financial assets vary in returns depending on external factors such as market conditions, economic uncertainty, volatility, and other aspects such as investment timing and goals. All financial assets are not correlated with each other. Hence, diversifying one’s portfolio across multiple sectors and asset classes can bring down the risk component of a portfolio. This article seeks to throw light on asset allocation’s meaning and significance.
Table of Content
Meaning of Asset Allocation
Let us begin by understanding what is the meaning of asset and what is the meaning of allocation. An asset is something that provides a current or potential economic benefit. Allocation refers to the process of assigning resources to a particular participant.
So, what is asset allocation? Asset allocation is an investment strategy by which investors attempt to balance risk and reward by adjusting the percentage of the amount invested in an asset in a portfolio according to their goals, risk tolerance, and investment horizon. Asset allocation typically involves dividing one’s money across various asset classes such as equities, fixed-income, cash, and cash-like assets. Investments outside these categories, such as commodities and real estate are considered alternative assets. An efficient asset allocation helps investors safeguard their money and maximize the growth potential of their portfolio.
Why Is Asset Allocation Important
One of the primary benefits of asset allocation is that it helps investors spread their investments across various asset classes to protect the portfolio from any downturns by one asset. Let us look at the importance of asset allocation in detail.
- Disciplined approach – It is not uncommon for investors to exhibit irrational behavior when making investment decisions. Exploiting profits from the volatile stock markets can be overwhelming, causing investors to make irrational decisions. A well-organized portfolio with specific asset allocation helps investors follow a disciplined approach to manage their portfolios efficiently.
- Steady Performance – Investors spend a significant part of their time exploring various best-performing schemes. Historical portfolio returns analysis provides substantial evidence that asset allocation is the most critical aspect of portfolio performance. The other factors that influence the performance of a portfolio include security selection, market timing, and other external factors that could affect the markets.
- Portfolio Stability – Diverse asset classes may perform differently during the various stages of an investment cycle. Efficient asset allocation ensures the investors’ portfolio returns remain largely stable and yield good returns across different investment cycles.
- Portfolio Rebalancing – Various asset classes can outperform or underperform in various market conditions. Rebalancing your portfolio ensures your asset allocation does not deviate significantly from your target allocation.
Age-Based Asset Allocation
The combination of assets you might want to hold shifts with age. When you are younger, you may want to invest more in risky stocks promising high growth over a more extended time horizon. A longer horizon gives young investors more time to ride out market volatility.
With advancing age, investors would typically want to shift their asset allocation. With increasing responsibilities, investors might want to invest across asset classes that give consistent returns or are not too risky. Moreover, as retirement approaches, investors may shift to even less-risky avenues such as bonds and cash equivalents to protect their savings from market risks.
The rule of thumb for age-based asset allocation is to subtract 100 from your age to understand how much exposure you could withstand with respect to equities. If you are aged 20 years, you may want to invest 80% into equities.
There are commonly two approaches for investing across asset classes. The first is the average mode based on the average risk appetite, as mentioned in the above rule. The other approach is the aggressive mode, typically followed by investors willing to take on higher risk than average investors.
All financial assets carry an element of risk ranging from low to high. Given below is a deep dive into the age-based asset allocation approaches. It states that investors can take higher risks at a younger age, and the asset allocation needs to change to less-risky assets over time.
| Age | Asset Class | Average Mode | Aggressive Mode |
| 20 years | Equity | 80% | 90% |
| Real Estate | 0% | 5% | |
| Cash | 5% | 5% | |
| Debt | 15% | 0% | |
| 30 years | Equity | 70% | 80% |
| Real Estate | 0% | 15% | |
| Cash | 5% | 5% | |
| Debt | 25% | 0% | |
| 40 years | Equity | 60% | 70% |
| Real Estate | 10% | 15% | |
| Cash | 5% | 5% | |
| Debt | 25% | 10% | |
| 50 years | Equity | 50% | 60% |
| Real Estate | 18% | 20% | |
| Cash | 2% | 2% | |
| Debt | 30% | 18% | |
| 60 years | Equity | 40% | 50% |
| Real Estate | 18% | 30% | |
| Cash | 2% | 2% | |
| Debt | 40% | 18% |
What Is an Asset Allocation Fund?
Asset allocation funds represent balanced mutual funds where investors can invest in equities and fixed-income securities. Like mutual funds, a professional fund manager deals with asset allocation funds. They monitor the markets constantly and design asset allocation strategies that suit investor requirements. Asset allocation funds provide the option to design the right asset mix according to each investor’s requirements and risk appetite. The fundamental advantage of these funds is that they ensure optimal return on investment in a diversified portfolio.
Disclaimer: Investments in securities markets are subject to market risks, read all the related documents carefully before investing.
