Understanding Asset Allocation and Different Asset Classes
Since the inception of stock exchanges, the Indian economy has witnessed the rise of many new asset classes. Investing all the funds in one single security is not an intelligent financial move. That is why distributing your money in different asset classes is important. Asset allocation can diversify your financial portfolio thereby narrowing the risk factor and maximising the chances of optimal returns.
This article helps you understand asset allocation, how it works, its importance, different asset classes, and asset allocation strategies. Read on!
What is the Meaning of Asset Allocation?
Asset Allocation is an investment strategy an investor opts for to balance out the risks and growth potential of an investment scheme. It involves dividing one’s investment portfolio into different assets such as stocks, bonds, cash-like assets, gold, real estate, etc.
The decision to allocate assets depends upon the investor’s risk appetite, investment goals, time horizon and return expectations. By diversifying one’s investment into different asset classes, one can mitigate the risks of losses correlated with a single asset class.
How does Asset Allocation Work?
The primary goal of allocating assets is to minimise losses. Investors opting for this process will aim to distribute their investment among assets from diversified categories. The reason behind the allocation of funds is that different asset classes have different underlying factors behind their price movements.
This ensures that even if one particular asset class accumulates losses, the other asset classes may remain unaffected or even deliver enough returns to deliver an overall profit. This is the principle behind diversification that enhances one’s portfolio and brings in a certain degree of stability.
Also Read: Asset Management Company (AMC)- Definition, Workings And How To Choose One
Why is Asset Allocation Required for Investors?
Asset allocation is required because it plays a vital role in reducing the overall volatility and maximising the returns. All assets are not related to each other, which makes the management of risks and returns of your portfolio easier.
Other than reducing risk, asset allocation also lets you benefit from upsides in different asset classes. Investing in a mix of asset classes increases your chances of earning higher returns. The decision to incorporate asset allocation strictly depends on your risk tolerance and investment objectives.
Types of Asset Classes
1. Equity
Equity is an asset class that includes stocks or shares which represent the ownership of a company. Investors buy stocks hoping to sell them at a higher price to earn profits. Another goal of buying equities is to earn dividends in cash or additional stocks.
2. Real Estate
Real estate includes residential apartments, plots, villas, commercial buildings, industrial areas, etc. These days, the interest in investing in real estate assets is on the rise. There is a wide scope to generate high returns and profitability by renting to tenants or flipping a house.
However, different factors play an integral part in the scenario of generating greater ROI. Factors like socio-political scenes, project movement and city planning, are all connected to generating better ROI (Return on Investment).
3. Cash
The cash asset class is well known for its high liquidity. It has a high value for investors looking for assets that can be frequently reassessed and reallocated to different investments.
This asset class includes treasury bills, commercial papers, money market instruments, etc., with a maturity of up to one year. No other asset class offers such transactional freedom. The downside of this asset class is its incapability to beat market fluctuations. Also, the returns gained are almost negligible.
4. Commodity
Many investors buy and hold on to commodities to maintain a high value in their portfolio as this asset tends to retain its value. Some examples of commodities are— crude oil, corn, natural gas, wheat, electricity, copper, etc.
Market undercurrents vary for each element. Other commodities like artwork and collectables are directly purchased. Investors can also have the option to directly invest in gold, silver and other precious metals through commodity markets.
4. Derivatives
Derivatives are contracts between two or more parties. Their value is derived from underlying securities like bonds, stocks, commodities, interest rates, etc. The price of each derivative varies based on market fluctuations. Debt, foreign exchange, equity shares, commodities, and market indices are all underlying assets which are used as derivatives.
Different Asset Allocation Strategies
1. Risk-Based Asset Allocation
There are five categories of risk tolerance that investors, in general, are labelled with-
- Conservative
- Income
- Balance
- Growth
- Aggressive
Risk-based asset allocation involves separating investors depending on their risk appetite to decide their suitable investment options. For instance, conservative investors have the lowest risk tolerance and ideally aim to receive consistent returns on their investments. Hence, they invest in shares where the chances of return are predictable.
Aggressive investors, on the other hand, are the complete opposite. They prefer to take high risks, knowing that the greater the risk, the higher the possibilities of market-beating returns. Their ability to take risks reflects in their diverse portfolio.
2. Age-Based Asset Allocation
Age-based asset allocation is a strategy dependent upon the investor’s age. In this investment strategy, the older an investor, the lower should be his/her equity allocation. Instead, he/she should invest more money in less risky asset classes.
Using this strategy alone seems quite insufficient as it does not consider the factors like risk tolerance of the investor or even the objective behind the investment.
3. Tactical Asset Allocation
This is an active investment management strategy that is flexible and maximises short-term investments. In this, investors can gain maximum profits by taking advantage of market fluctuations or attractive investment opportunities.
The allocations of assets are adjusted to cope with market dynamics, bringing in greater returns with low-risk associations. After garnering the maximum profit from short-term investment strategies, the investor rebalances the portfolio as was previously set.
4. Dynamic Asset Allocation
Dynamic asset allocation involves frequent weightage adjustments depending on the current market scenario. The investor studies each asset class’s performance and the current market conditions to decide what suits his/her investment goals.
The process revolves around strictly observing the market trends and closely monitoring the investment portfolio. Hence, to successfully implement this strategy, the person in charge must have good knowledge and great skills to tactfully manage the portfolio.
Factors That Affect Asset Allocation
1. Age
Age plays an important factor to consider for investors. Younger people enjoy the privilege of being able to take more risks with their investments. People within the age bracket of 20-30 years have ample time to recover from any major setbacks that might occur while investing in high-risk assets.
People within the age group of 30-55 years tend to or rather should invest in moderately risky assets. That is why they should invest all their savings in equities. Investors who are nearing 60 should invest in a conservative manner. Investing in debt and fixed income instruments are two viable options for them.
2. Risk Profile
While conducting any form of investment, the element of risk needs to be taken into account. Your risk appetite will decide which assets you select to invest in. You can diversify your portfolio and invest in equities if you have an aggressive risk appetite.
Someone with a moderate risk tolerance can invest in a combination of equity and debt. For people with low-risk appetites, fixed-income instruments can provide them with the stability they might be looking for.
3. Time Horizon
To some extent, the time horizon is related to your investment goal and risk tolerance. If your investment plan is for three years, it is considered to be a short-term financial goal. Any investment plan that spans 3-7 years is a medium-term investment goal. Long-term investment goals are any plans that stretch out beyond the span of 7 years.
Asset allocation based on your time horizon is beneficial if you map out the risk factor. If you are planning to invest for a short period, say 3 years, you should avoid investing in equities. Anyone planning to invest for seven years or more can opt for maximum equity allocation and then reduce the distribution with each passing year.
4. Goal-based Factors
Every investor has different goals with their investments. Some may plan to invest for a longer period and in assets with high-risk factors. Investment goals like home loan repayment, saving up for child education or retirement are some long-term investment goals.
Others might opt for a conservative approach to reduce the risk and gain maximum profit. Hence, each investor’s plan of asset allocation will differ accordingly.
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The Connection between Asset Allocation and Diversification
Investors can allocate their funds into different asset classes whose performance is not highly correlated to diversifying their portfolios. The more diversified the portfolio, the greater possibility of curbing down the risks attached to any form of investment.
The performance of each asset class is not similar to one another. So, even if one asset class is not performing well, others might. Diversifying your assets among different asset classes will provide you with some certainty. Even if one of the assets fails to perform well, funds allocated in other asset classes might provide you with some benefit in return.
Final Word
Making a proper investment plan can be quite tricky. However, by implementing asset allocation in your investment strategy, you can achieve your financial goals. Make sure to conduct thorough research on the market scenario. Attain enough knowledge to understand how different assets react to market fluctuations.
After studying, map out a strategy of investment that would work in alignment with your goals. Remember to modify and diversify your assets to create a portfolio that suits your financial needs. And lastly, keep monitoring the market to get more clarity regarding the movement of your investment.
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FAQs on Asset Allocation
Ans: Rebalancing your portfolio can be conducted once a month or after every quarter. Other than period rebalancing, you can also change your portfolio according to the percentage of deviation in the asset’s performance.
Ans: Equities offer the potential to deliver the highest returns among asset classes. According to several studies, it is the only asset class that has delivered inflation-beating returns over the long term. Gold and real estate are other high-return asset classes.
Ans: The primary purpose of asset allocation is to diversify your portfolio and cut down on major losses. Allocating funds under multiple asset classes mitigates the total risks of your investment portfolio, and you may get high returns.
Ans: Asset allocation funds refer to mutual funds that allocate funds in different asset classes like fixed income and equities, depending on the investor’s goals. There is a set amount that is invested in fixed income assets and equities depending on the particular type of scheme.
Ans: The four main types of mutual funds based on asset class are:
Equity Funds
Debt Funds
Money Market Funds
Hybrid Funds
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
