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Understanding Asset Allocation – A Portfolio For Rainy And Sunny Days

How an optimal asset allocation strategy can help you minimise portfolio risk while maximising returns. By Radhika Gupta.

Baskets of strawberries and blueberries sit on display for sale at a stall. (Photographer: Brent Lewin/Bloomberg)
Baskets of strawberries and blueberries sit on display for sale at a stall. (Photographer: Brent Lewin/Bloomberg)

Don’t put all your eggs in one basket, goes the famous proverb. ‘Asset allocation’ and ‘portfolio diversification’ are the most extensively used phrases we come across when reading about investment, but what do they mean?

Picture a vendor who sells both sunglasses and umbrellas to ensure his sales happen around the year, across seasons. Similarly, investors too must invest in a mix of asset classes to weather all market conditions. Simply put, asset allocation is a strategy that aims to create an optimal balance between risk and reward by allocating investments across multiple asset classes.

Optimising Your Asset Allocation

While the specifics of asset allocation differ from one individual to another, the broad approach is governed by three main factors: the investor’s goals, risk profile and time horizon. Your investment time horizon is the expected number of months, years, or decades that you need to stay invested to achieve a specific financial goal. Determining this is important because a longer investment horizon gives you the liberty to include high-risk investment instruments in your portfolio as market volatility gets smoothened out over the long-term. In contrast, an investor with a shorter time horizon might stick to less risky options.

Additionally, investors might not achieve optimal diversification just by merely spreading their investments across assets. Categories within the broad asset classes of debt and equity carry varying levels of risk that behave differently over time, and can impact the overall risk of the portfolio. While a large cap fund, by virtue of being categorised as an equity asset, would fall into the high-risk bucket, it might be less risky as compared to a credit risk fund.

Know Your Strategy

For your asset allocation strategy to give you the desired results, you need to identify which portion of your portfolio is strategic, and which portion is tactical.

  • Strategic Asset Allocation: This strategy entails creating a target allocation for various assets, which depends on an investor’s long-term goals and risk tolerance. It is akin to a buy-and-hold strategy where investors maintain the target allocation and rebalance only in response to a change in the financial landscape or personal circumstances.
  • Tactical Asset Allocation: This is an active asset allocation strategy that entails frequent rebalancing between asset classes in an attempt to capitalise upon short-term market opportunities. This strategy carries a higher level of risk but can generate higher return in the short-term.

The key is to determine a strategic asset allocation strategy and then allocate a certain percentage of the overall portfolio to tactical shifts.

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Aligning Your Strategy With Your Goals

The purpose of any investment strategy is to help you achieve your financial goals. However, determining an appropriate asset allocation model for a financial goal can be a complicated task. While the idea is to simply pick a mix of assets that offer the highest probability of meeting your financial goals within the desired level of risk, in reality, this can be very challenging to execute. The challenge is further enhanced by the fact that as you reach closer to your goal, you will need to adjust your mix of assets.

Investors can create customised asset allocation strategies to meet their different objectives. A young investor who’s saving for his retirement i.e. a long term goal, may allocate a larger portion of his investment to equity funds while another who might be saving for purchasing a home in the next 10 years might choose to spread his investments over equity funds, fixed-income funds and/or balanced funds. At the other end of the spectrum could be an investor who is saving to purchase a car in the next year and might choose to create a conservative investment mix of fixed deposits and short-term bond funds.

Additionally, as you move closer to your goals, it’s advisable to create a conservative tilt and switch from an equity fund to a money-market fund, in order to protect the returns generated and meet the targeted goal.
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Benefit From Every Scenario

The core principle of an asset allocation strategy is to gain exposure to multiple asset categories that respond differently to certain market conditions. Historically, the returns from the major asset classes have shown little to negative correlation, implying that while a certain portion of the portfolio might react negatively to a particular development, there is another portion of the portfolio that might react positively to the same development. In addition to mitigating portfolio risk, asset allocation has many other benefits that can help optimise portfolio returns.

Systematic rebalancing prevents the need for an investor to constantly try and time the markets.

Since an asset allocation strategy dictates a percentage-based allocation to debt and equity assets, any change in the portfolio value or skew in asset performance can be systematically handled by adhering to the asset allocation strategy.

Asset allocation helps overcome cognitive biases and allocating a disproportionate amount to any one asset class due to higher past returns or any behavioural biases.

Since an asset allocation strategy is fairly objective and scientific, it can prevent investors from taking portfolio decisions that could hurt their return mandate.

Assume that an investor has allocated 60 percent to equity funds, 30 percent to fixed income funds, 5 percent to fixed deposits and 5 percent to cash. Now, in a bull market, the value of the equity portion is likely to grow and thus assume a higher proportion in the overall asset allocation mix.

However, as the value of equities grows, an investor is plagued with multiple questions.

  1. Should I book profits at current levels or wait it out for higher returns? and
  2. Should I follow the herd and continue increasing my exposure to equities?

The answer to both these questions lies in your asset allocation strategy. If your asset allocation strategy requires you to maintain an equity exposure of 60 percent, then as this exposure goes beyond 60 percent, maybe to 75 percent, it would indicate that it is time to book profits and bring the exposure down.

An optimal asset allocation strategy can help you minimise portfolio risk while maximising returns, prevent the need for timing the market and help develop investment discipline. 

A financial advisor can help you determine the various factors that influence the asset allocation decision and subsequently arrive at an optimal strategy.

Radhika Gupta is Chief Executive Officer at Edelweiss Asset Management and the views expressed are her own.

Disclaimer: Mutual fund investments are subject to market risks, read all scheme related documents carefully.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.