The goal of investing is to earn profits, for which you need to allocate your funds in the right mix of fixed income instruments, mutual funds, stocks, and other asset classes.
What is Asset Allocation?
The term ‘asset allocation’ refers to an investment strategy that balances risk and reward. It segments an investment portfolio into different types of asset classes such as real estate, fixed income, equity, cash, cash equivalents, etc. Asset allocation enables an investor to reduce the risk impact on their portfolio since every asset class has a different correlation with the others.
Importance of Asset Allocation in Portfolio Management
To achieve financial empowerment, you need to have the right asset allocation. One might feel that now is the best time to start a SIP in mutual funds since it is currently the highest-return generating asset. However, an investor cannot predict the direction in which an asset class will move at any given time. So, one must do a prudent asset allocation by answering the questions given below:
- Where to invest?
- How to invest?
- How much to invest?
You need to select the appropriate asset classes and determine their holding ratio in your portfolio. Most investors have asset classes such as debt, gold, and equity. A ratio for dividing money into these asset classes is then decided. One of the factors you should consider when deciding the ratio of division is your age.
Factors that Influence Asset Allocation
An investment portfolio can change consistently, and one needs to review and monitor it periodically. There is no one-size-fits-all rule for attaining your financial goals through investments. How you allocate your assets can change as per your life stages. The asset classes selected by a young investor would be different from those chosen by a middle-aged or older investor.
Another aspect that will impact asset allocation for an individual is the risk capacity and attitude. For example, a young investor can have a higher risk tolerance since they are at the start of their career. At a young age, one can expose a significant portion of their portfolio to equity investments.
You could use the ‘100 minus age’ rule of thumb for equity allocation. As per the rule, if you are 30 years old, 100-30 gives you 70, which is the percentage of equity investments you must hold in your portfolio.
Asset Allocation vs. Portfolio Diversification
When it comes to the topic of asset allocation, it is essential to look at portfolio diversification. Asset allocation ensures that the asset classes you are looking to invest in agree with your risk appetite, expected returns, and investment horizon. Conversely, portfolio diversification looks at minimizing investment risks and maximizing returns. The latter does not consider the investor’s profile.
Conclusion
Asset allocation is a vital technique to build an investment portfolio that helps you fulfill your needs and expectations. Before investing, you must understand your risk capacity, expected returns, and investment horizon. Understanding these three aspects will help you make more informed decisions about your investments. If you’re ready to start a SIP today, download the Tata Capital Moneyfy App and kick-start your investment journey!
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