Asset allocation is the first thing your financial planner will advise you about when you want help on your finances. However, asset allocation is a highly misunderstood concept. Here we’ll tell you exactly what asset allocation is, the myths surrounding it and how to make the most of it.
What is asset allocation?
Asset allocation is a strategy that will help you balance the risks and rewards involved in investing. Essentially, it is a process of dividing your assets between different asset classes based on your risk profile, investment horizon and the goals that you want to reach. Ideally, this process should be undertaken as soon as you create a financial plan. The typical asset classes that are part of the allocation are equity, fixed-income and cash.
What are the types of asset allocation?
First, we have strategic asset allocation. Under this method, you decide the asset allocation based on the returns expected from the asset class and your own return expectation. For instance, if stock prices have given 12% per year for the last 5 years and fixed-income has returned 8% per year, you can have 50% allocation to equities and 50% to fixed-income given your return expectation is 10%.
Then comes weightage asset allocation. Under this method, you keep adjusting your portfolio to reflect your initial asset allocation. This is because prices of investments, especially in equity, keep changing. So, your initial asset allocation will never remain the same. You need to make changes to the investments as and when your asset allocation starts changing significantly.
The third is tactical asset allocation. Here, you keep changing your asset allocation based on economic conditions, market conditions and your own financial situation. So, you keep making tactical changes to your asset allocation to suit your needs.
The fourth is dynamic asset allocation. Under this method, you constantly keep changing your asset allocation in order to get the best returns. This is generally not recommended for individuals as the cost of managing such an asset allocation will be very high.
What is the most popular myth regarding asset allocation?
The most popular myth is the age-based asset allocation. Here, you need to make asset allocation based on your age. For example, if you are 30 years old, then you put in 60% in equities, 30% in debt and the rest you keep as cash.
This strategy is totally wrong for several reasons. Firstly, it doesn’t take into account your risk appetite. If you have a low-risk appetite, then pure equities might be all wrong for you. Secondly, it doesn’t take into account the financial situation of the person. For instance, according to the strategy, if you are 60 years old, you will invest 30% in equities which will be quite high, given that you might have retired by that time and might not have a steady (or any) income. The third and most important thing that this strategy ignores is the financial goal that a person wants to reach. For example, you want to save for a car downpayment and need it in the next three years. Being a 30 year old, according to this method, you would have invested 60% in equities. You are actually putting your capital at risk and the time horizon is small. For this goal, you need to have more money in debt.
What should you do?
First, create a financial plan based on your goals. Then, have your asset allocation set based on the goals and the time horizon to meet those goals. For example, if you are saving for your retirement, you can have as much as 80% of your investments in equities. However, if the goal is buying a house in the next five years, the equity portion should be much lesser. And of course, you need to keep an eye on your asset allocation so that it doesn’t get out of hand. And if you are unsure, always get the help of a financial expert. It’s your money after all and you do want to get the best out of it, right?