What is Asset Allocation: Definition, Benefits and Strategies?

4. Gold (Commodities): It is possible to invest in a wide range of commodities ranging from agricultural goods like cotton to raw materials like crude oil through a commodities exchange. But in India the most common commodity one can invest in is gold and recently silver. In case you are wondering how to invest in gold, you can do so in the physical form or through a digital investment option like Gold Mutual Funds or Gold/Silver Exchange Traded Funds.

5. Alternative Investments: This is an emerging class of investments that has some similarities to mutual funds but the underlying asset can be diverse like commercial real estate or infrastructure projects like toll roads. Examples of alternative investments in India include Real Estate Investment Trusts (REITs) and InvITs (Infrastructure Investment Trusts).

6. Cash and Cash Equivalent: While keeping cash or maintaining a large bank balance might not generate high returns it is essential for providing liquidity to the investor. Additionally, there are cash-equivalent investments like CBLO (collateralized borrowing and lending obligation) and TREPs (Tri-party Repo), certificate of deposits, etc. which many individuals and institutions use for short-term parking of funds while ensuring liquidity and easy accessibility of the funds.       

What are Different Asset Allocation Strategies?

While there are numerous asset allocation strategies that an investor can choose from, these strategies can be classified into 3 broad categories. Details of these 3 key asset allocation strategies are:

Strategic Asset Allocation

Strategic asset allocation strategy determines the investment allocation across different asset classes based on the investor’s needs like age, financial responsibilities, current assets, risk tolerance, etc. One of the simplest methods of strategic asset allocation is based on age and commonly known as age-based asset allocation. This method can be summed up using the below formula:

(% of Equities in Investment Portfolio) = 100 – (Age of Investor)

So, if an investor is aged 45 years, the ideal equity allocation as per strategic asset allocation will be,

% of Equities in Portfolio = (100 – 45) = 65%

Moreover, as the age of the investor increases, the proportion of equity in the investment portfolio will decrease. So, the equity allocation of a 50-year old investor will decrease to 50% and so one. The key benefit of this strategy is that it is easy to understand and promotes long term investment in key asset classes to help with wealth creation. 

Tactical Asset Allocation

Some investors consider the strategic asset allocation strategy to be quite rigid and for such individuals, tactical asset allocation can be a viable alternative. The strategy of tactical asset allocation attempts to capitalize on market movements and generate profits in the short-term while ensuring that the overall investment portfolio stays on track to achieve the long-term investment goals.

An example of this strategy would be increasing the equity allocation of the portfolio temporarily when equity markets are witnessing a downward trend. Subsequently as equity markets recover, the investor sells the extra equity allocation for a profit and rebalances the investment portfolio by increasing allocation towards other asset classes like debt mutual funds, gold investments, etc.

As you can see, to successfully implement this strategy, the investor is required to be well-versed with various aspects of investments. This is important so that one is able to time his/her entry and exit from different asset classes to benefit from market movements and maximize profits.  

Dynamic Asset Allocation

In one way, dynamic asset allocation is similar to tactical asset allocation as both strategies aim to generate higher returns by taking advantage of changing conditions of equity and debt markets. There is however a key difference – while tactical asset allocation involves repeated manual intervention by the investor, dynamic asset allocation automates the process without any preset allocation towards different asset classes.

So, investors engaged in dynamic asset allocation have the flexibility of changing their portfolio allocation from 0% to 100% across any of the chosen asset classes based on market movements. What’s more this asset allocation strategy usually involves 3 or more asset classes in order to diversify the investment portfolio. Key asset class options that are available to investors when implementing the technique of dynamic asset allocation include – equities, debt, gold and real estate. 

Lower Portfolio Volatility

All investments are prone to some volatility depending on prevailing market conditions. But, while you might not be able to completely eliminate volatility from your portfolio, asset allocation can help decrease and control it to some extent. This is because, as you diversify your investment across different types of assets, changing market conditions would prove beneficial for some of your investments so that overall portfolio volatility is reduced.  

Returns Optimization

Market-linked investments like stock, bonds and mutual funds go through cyclical periods of high and low returns even periods of negative returns at times. One of the key benefits of diversifying your investments across multiple asset classes like equity, debt, gold, etc. is that you maximize your returns during different market highs and ensure downside protection during market lows. This way your investment portfolio will be ideally placed to outperform the broader market under various conditions.   

Helps Achieve Financial Goals

One invests money in order to achieve key financial goals whether it is a vacation, down payment on a new car, buying a new house, retirement planning, etc. Through asset allocation, it is possible determine which basket of investments is ideally suited to achieve such specific investment goals. This is because implementing your chosen asset allocation strategy will help you stay on course to help you reach your specific financial goals. 

Factors Affecting Asset Allocation

No single asset allocation strategy is ideally suited to the needs of an investor. This is because each investor has different reasons for making investments and also their goals differ. Below are 4 key factors that affect the choice of asset allocation strategy chosen by investors: 

Age

Age of an investor plays a critical role in asset allocation as it is key to determining how long an investor can stay invested. As a rule of thumb, younger investors can invest for longer periods so they are minimally impacted by short term volatility of their investments. This makes it possible for younger investors to allocate a large proportion of their investment towards equities so that they can focus on long-term wealth creation.

On the other hand, investors who are closer to retirement typically have greater financial responsibilities and need to have easy access to funds in a relatively shorter term. For such investors, the proportion of equity investments in the portfolio may need to be limited while a greater proportion of assets might need to allocated towards other asset classes that have relatively less short-term volatility like debt and gold, which can be achieved through specific types of mutual funds.      

Risk Tolerance

Risk Tolerance is defined as the ability of an investor to tolerate a loss and risk is an integral part of any investment. Investors who have high risk tolerance can take a greater degree of risk to the principal amount invested and focus on earning higher returns. On the other hand, investors with lower risk tolerance tend to prefer more conservative investments including guaranteed return options like fixed deposits and recurring deposits. This is one of the key reasons why risk tolerance of an investor determines the proportion of assets that is invested in different asset classes.   

Investment Tenure

One of the key factors that impact investment tenure is the investor’s goal for making the investment. If one is investing for short periods of up to 1 year, capital protection might emerge as the primary need for the investor as compared to wealth creation. In such cases, investments that have low volatility in the short term like bonds and other debt instruments would emerge as the preferred investment option. On the other hand, asset allocation towards equity-oriented investments would tend to be higher if one is investing for a tenure of 5 years or longer. This is how investment tenure impacts the allocation of the investment portfolio across different asset classes.      

Frequently Asked Questions (FAQs)

Q. When should I change my asset allocation across different investments?

A. Typically asset allocation in your portfolio should change as you get closer to your investment goals, when your investment priorities change or you want to take advantage of prevailing market conditions. Key life events like marriage, birth of a child, purchase of a house, etc. are some other situations when you should consider changing your asset allocation.

Q. Which asset allocation strategy is suitable for me?

A. No single asset allocation strategy that fit the investment needs of all individuals. Hence, you will need to consider your unique situation before you can select a strategy of allocating assets so that you are on track to reach your short and long-term financial goals. In case you need help in determining this, it is a good idea to take help from a financial planner before making a decision.

Q. How often should I rebalance my investment portfolio?

A. Experts suggest that you rebalance your portfolio no less than once in a year so that you are able to track your investments accurately before making changes to your existing portfolio. Moreover, you should not rebalance your portfolio multiple times in a year as this would impact the performance of your long-term investments such as mutual funds that primarily invest in equities.

Q. What are 3 key factors when determining asset allocation?

A. In addition to other factors like investor’s age and financial responsibilities, 3 key factors that can help you determine how to allocate your investments across different asset classes in your portfolio include – financial goals, risk tolerance and investment horizon. 

Q. Is asset allocation the same as diversification?

A. While diversification and asset allocation are closely related; they are not the same thing. Diversification can be defined as the process of spreading your investments across different asset classes so that your dependence on any single investment option is minimized. Asset allocation, on the other hand, is a process by which you can decide how much you should invest in each asset class so that your portfolio performance is maximized while overall risk is minimized.