As is the case in our day-to-day lives where we often find ourselves realizing the importance of the axiom that “variety is the spice 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 to allude to the ‘variety’ element in finances and it is considered one of the building blocks of a successful financial strategy. Asset allocation is the process through which as an investor you can maintain requisite levels of diversification.

However, despite financial advisors repeating often that diversification is sacrosanct, maintaining the right level can often get pushed to the backseat in the investment game. Creeping up of inherent biases can make it hard for even the most focused investors to adhere to optimum diversification levels while managing investments. However, asset allocation is the cornerstone of successful investments without having to maneuver beyond one’s risk tolerance spectrum.

What is asset allocation?

Investors channelise money in investments and different asset classes for fulfilling various financial goals. Whether those investments turn out to be successful within the estimated time horizon depends on three factors - returns, risk and liquidity, all three of which are correlated.

The crux of asset allocation lies in maintaining a balance between these three elements by investment in different kinds of investment avenues such as stocks, fixed income instruments and real estate. The idea of funneling money in numerous investment classes is that it can help flatten risks and optimize rewards because when the investments are spread out, risk from one or more assets can be offset by investments in other assets.

The risk-return tradeoff is the core of asset allocation. The underlying theory is that each asset class will have a unique level of return and risk and hence will perform differently in a particular span of time – or in other words, various types of asset classes will never exhibit the same performance trends at the same pace simultaneously. Thus, while formulating the right asset allocation, gauging correlation between the different asset classes is of paramount importance.

Why is asset allocation important?

Consider the following example: there is a shop that sells only snow boots – of every imaginable colour and size for all age groups. Unless that shop is in a place where there is snowfall all the year round, it is highly unlikely for the business to be profitable at all times of the year and if you add climate change to the scenario, the prospects look bleaker. In order to maximize revenue, the owner starts stocking up on winter garments too and eventually branches out to selling other kinds of goods too so that the footfall remains unaffected irrespective of what time of the year it is.

Asset allocation has a similar premise – excessive concentration of a limited group of asset classes in your portfolio can compromise your financial well-being. For instance, investors whose portfolios comprise only equity investments are at the risk of incurring heavy losses every time the stock market gets into a roller coaster ride due to global events. Hence by maintaining portfolios with the right weightages to other asset classes such as corporate bonds, fixed deposits or gold, you can continue earning steady returns without your entire investment slipping into the danger zone at once.

When it comes to asset allocation, there is no fixed formula because the one-size-fits-all formula can be a recipe for disaster. Copy pasting other people’s portfolios without due research on your part and simply based on hearsay may generate enviable returns in bursts in the short term but it may jeopardize your overall financial health in the long-term. Your asset allocation strategy will be based on a multitude of factors, the most important ones being your risk-taking abilities, age, goals, your investment horizon and your existing liabilities too. Also, random attempts at diversification or tweaking asset allocations without much thought or as a knee-jerk response to external factors can throw your financial goals off gear completely.

Disclaimer: An Investor Education Initiative by Mirae Asset Mutual Fund

For information on one-time KYC (Know Your Customer) process, Registered Mutual Funds and procedure to lodge a complaint, refer to the knowledge center section available on the website of Mirae Asset Mutual Fund

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.


IE Disclaimer

An investor education initiative by Mirae Asset Mutual Fund.

For information KYC process, Registered Mutual Funds and the procedure to lodge a complaint, refer knowledge centre section available on the website of Mirae Asset Mutal Fund.

Mutual fund investments are subject to market risks, read all scheme related documents carefully.