Importance of Asset Allocation

Importance of Asset Allocation

Have you ever stopped to wonder why you should never put all your eggs in one basket? The answer is obvious. If you were to drop that basket, then all the eggs that you own would break resulting in a total loss. However, if you were to split your eggs among two or more baskets then even if you dropped one basket, your loss would be limited to only those eggs in that one basket. The eggs in the other baskets would be safe. Asset allocation in the investment world works in a similar manner. Just that the eggs are replaced by your money and the baskets are replaced by different asset classes.

Asset allocation is simply a method that helps investors to balance risk through diversifying their investment across multiple asset classes. This means that instead of investing all the money in a single asset class, investors can instead choose to invest their money across multiple asset classes.. Each asset class has a different level of risk and return and thus, behaves differently over time. Additionally, market conditions and factors that might have an adverse impact on one asset class might have little or no impact on another asset class. Consequently, factors that lead to one asset class outperforming during a given timeframe might cause another to underperform. The result is less portfolio volatility for investors since these, often opposite movements,might offset each other.

However, it is very difficult to predict which among the various asset classes will perform in the future. Asset allocation involves dividing an investment portfolio among different asset classes such as fixed income, stocks, commodities, real estate and cash, etc. The process of determining which mix of assets to hold in your portfolio is unique to each individual. It is ideally based on your financial goals, the time horizon in which you wish to achieve them and your risk tolerance level.

Time-Horizon - If your goals are long term in nature, you may be comfortable investing in a riskier or more volatile asset class like equities because you can wait out slow economic cycles and the numerous ups and downs of markets. However, if your time horizon is short, you are likely to assume lower risk.Generally, the younger you are, the more risk you can afford to take. As you grow older, you may be more interested in preserving your capital/savings since a large decline near your retirement may result in compromising your lifestyle.

Risk Tolerance - Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand in their financial planningand is a major factor in deciding your asset allocation.

Return Requirement – the very purpose of an investment is to aim to generate returns that can help an investor meet his financial goals. There are some assets that have the potential to generate relatively higher returns albeit with higher levels of risk, while there are other assets that generate low to stable returns with low risk component. Portfolio allocations are largely contingent upon the returns that the portfolio is required to generate.

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