Asset allocation is the term used for the investment strategy adopted by a portfolio manager or an investor, in an attempt to balance the risks versus the rewards, by making adjustments to the percentage amounts invested into different assets of the portfolio, in accordance with the investment horizon, goals and risk appetite of the portfolio manager or investor.
Financial assets differ from each other based on their returns and user requirements. The returns in turn are dependent on various market conditions. Diversifying investments across different asset classes tends to lower the overall risk of the portfolio. And this is where asset allocation comes into the picture.
Asset is also the term used for referring to the percentage mix of various asset classes like gold, equity, debt and real estate in the total investment portfolio. Asset allocation is also often used to refer to the percentage split between the equity, debt investments etc. Gold and real estate also make important asset classes, especially in the Indian context. In fact, in India, the gold and real estate allocations are far more significant than allocations made to financial assets.
Asset allocation can be:
Strategic asset allocation
It involves allocation of fixed percentages to the different asset classes throughout the investment horizon. The return from the portfolio is then calculated by figuring out the weighted average return of the different asset classes. For instance, if you invest 65% of your funds into stocks (delivering 15% returns) and 35% in government bonds (delivering 5% returns), then your portfolio’s mean return would be 11.5%.
Tactical asset allocation
This type of asset allocation strategy permits making short-term deviations from the ideal strategy in order to capitalize on the fluctuating market conditions and/or investment opportunities that present themselves from time to time. The investor stays moderately active and rebalances his/her portfolio into the original mix upon achievement of the short-term gains.
Dynamic asset allocation
This asset allocation strategy is suitable for active investors who constantly monitor their portfolios. These investors can modify their allocation percentages in real time, depending on the economic and market fluctuations. The investor may shift his/her allocations from volatile to less risky assets during the market correction phases, or shift to riskier ones during the market boom phases.
*Rule of 100
A popular thumb rule for measurement of risk tolerance of different investors, Rule of 100 is often used by investors to determine their asset allocation strategy. As per this rule, you must subtract the age of the investor from 100, and the figure you get is the maximum or suitable percentage that must be invested into equities. So, if you’re 35 years old, you should have no more than 65% allocated to equities in your portfolio. It’s an Orthodox asset allocation model that is suitable for passive investors.
On the whole, asset allocation is highly significant when it comes to overall financial planning, as it plays more critical role than many other factor, in the accomplishment of financial goals.
Mutual fund investments are subject to market risks, read all scheme related documents carefully.