A popular English axiom goes: “Variety is the essence of life.” In the world of personal finance too, variety has an important place. Financial planners, investment gurus and fund managers use the term diversification and it is considered one of the building blocks of a successful financial strategy. And the exercise through which investors can maintain diversification is called asset allocation.

Despite the importance of diversification being repeated time and again by financial advisors and the likes, many investors tend to overlook it. Even the most disciplined investors amongst us would have fallen prey to their inherent biases and let diversification fall by the wayside when managing their investments. However, asset allocation is sacrosanct if one wishes to get optimum results from their investment moves without having to jump beyond their risk tolerance spectrum.

Investors funnel money in investments for meeting certain financial goals and whether those investments can prove to be useful for attaining those goals depends on three factors - returns, risk and liquidity, all three of which are correlated.

Asset allocation refers to maintaining a balance between these three elements by investment in different kinds of avenues such as stocks, fixed income instruments and real estate. In other words, through asset allocation, investors strive to mitigate risks and optimize rewards by investing in different asset classes in a way so that risk from one or more assets can be offset by investments in other assets.

The risk-return tradeoff is the crux of asset allocation. The underlying principle is that each asset class will have a unique level of return and risk and hence will perform differently over time – various types of asset classes will never move at the same pace in the same direction in unison. When deciding the right asset allocation, correlation between the different asset classes is the most important factor that should be considered.

Consider the following example: there is a shop that sells only umbrellas – of every imaginable color and size. Unless that shop is in a place like London or Cherrapunjee, it is highly unlikely that the shop owner would be booking profits in seasons when chances of rainfall are slim. To tackle this issue, the shop owner starts selling winter garments too and eventually builds a separate section for bed linen, home décor and upholstery items and now she doesn’t have to look at the sky to anticipate sales.

Asset allocation works in a similar way – excessive dependence on limited varieties of asset classes can compromise your financial well-being. For instance, investors who had only invested money in equities, would have incurred heavy losses last year when the stock market went into a tailspin because of the pandemic. However, investors who had portfolios with the right weightages to other asset classes such as corporate bonds, fixed deposits or gold would have earned stable returns without the risk factor climbing to unmanageable levels.

When it comes to asset allocation, there is no fixed formula because the one-size-fits-all formula is dangerous in the world of financial management. Blindly mimicking your friend’s equity heavy portfolio may help you earn handsome returns temporarily but it may jeopardize your overall financial health in the long run. Your asset allocation strategy will depend on your risk-taking abilities, age, goals, your investment horizon and your existing liabilities too. It is also important to remember that random attempts at diversification or tinkering with asset allocations without much thought in reaction to external factors can do more harm than good.

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