By Hemant Rustagi
CEO, Wiseinvest Pvt. Ltd
Investment success largely depends upon how you create a balance between risk and expected return. Hence, your focus should be on managing risk and earning healthy returns without compromising your defined risk level. It is also important to remember that if you don’t take enough risk on your portfolio, you are likely to struggle to earn healthy returns required to meet your varied investment goals. Similarly, if you take too much risk with your investments, you may have to compromise on some of the important financial goals.
The real issue, therefore, is how can you find and maintain a balancing point that can help you achieve your investment goals at a risk level you are comfortable with. This is where an asset allocation strategy has a role to play. An asset allocation strategy aims at spreading your money across different asset classes such as equity, debt, real estate and commodities.
Asset allocation, if properly done, reduces portfolio risk more than it compromises returns. Simply put, if your portfolio has a mix of two investments that tend to go in opposite directions in different market situations, the combination has a stabilizing effect on your portfolio. That’s because different asset classes perform differently in different market conditions. For example, the stock market does well during an economic boom and loses ground during recessionary times. The bond market, however, goes in the opposite direction. While the recessionary conditions are good for the bond markets, a booming economy is not so good for it.
For an asset allocation strategy to be successful, it must be flexible enough to accommodate the changes in your financial circumstances as well as the changes in the economic cycle. It is important because the economic environment has a direct impact on the behaviour of the financial markets.
Here is what you need to do to work out an ideal asset allocation for your portfolio and maintain it through your defined time horizon:
-
The key deciding factors should be your time horizon, investment goals, and risk tolerance. Your time horizon is the expected number of months or years you will be investing to achieve your financial goals. If you have a longer time horizon, you may feel more comfortable investing in a riskier but potentially better asset class because you will have time on hand to wait out slow economic cycles as well as inevitable volatile periods. For example, while investing for your retirement, you can afford to put a greater percentage of assets in equities as you would generally have many years until you reach that stage. Risk tolerance is your ability and willingness to tackle short term market movements in exchange for greater potential returns over the longer term.
-
As prices of different types of assets do not move in tandem, a combination of different asset classes helps in managing the market risk efficiently. In fact, various studies have shown that asset allocation is the most important factor in determining returns from investing. However, you may need to rebalance your asset allocation from time to time, that is. to bring the current allocation level back to the original asset allocation level to maintain the balance in the portfolio.
-
As your investment time frame and goals change, so should your asset allocation. Be prepared to re-evaluate your asset allocation periodically. Some of the events that would prompt you to do so could be the education of your children, buying a house or retirement.
A key element for the success of an asset allocation is to adopt the right strategy for implementing it. Once the strategy is in place, the focus has to be on selecting the most appropriate instruments. The key considerations while selecting the instruments have to be flexibility, transparency, tax efficiency, and liquidity. This is where mutual funds score over other investment options.
