Asset Allocation 101
Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, gold and cash. The asset allocation that works best for you will depend largely on your return objectives, time horizon and risk tolerance.
Why Asset Allocation is So Important?
By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses.
Check the image below.
Over the last 20 fiscal years equities, debt & gold have outperformed each other at different times and no single asset class continues to outperform or underperform.
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| Image Source HDFC |
The Connection Between Asset Allocation and Diversification.
Diversification is a strategy that can be neatly summed up by the timeless adage, “don’t put all your eggs in one basket.” The strategy involves spreading your money among various investments in the hope that if one investment loses money, the other investments will more than make up for those losses.
Illustration of Moderately Aggressive Portfolio:
Moderately aggressive model portfolios are often referred to as balanced portfolios since the asset composition is divided almost equally between fixed-income securities and equities. The balance is between growth and income.
You can modify the proportions to suit your own individual investment needs.
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| Image source Investopedia |
Rebalancing your Asset Allocation.
You’ll find that some of your investments will grow faster than others. By rebalancing, you’ll ensure that your portfolio does not overemphasize one or more asset categories, and you’ll return your portfolio to a comfortable level of risk.
For example, let’s say you determined that stock investments should represent 60% of your portfolio. But after a recent stock market increase, stock investments represent 80% of your portfolio. You’ll need to either sell some of your stock investments or purchase investments from an under-weighted asset category in order to reestablish your original asset allocation mix.
Summary:
While each person's asset allocation strategy will be unique, consider these points:
- Invest in stocks, bonds and some gold.
- Consider increasing your stock allocation for long time horizons, predominantly use Index Funds to build your portfolio.
- Keep sufficient cash on hand for short-term needs.
By staying in the market through different market cycles, you reduce the risk that market volatility will adversely affect your portfolio's performance.