Practical Guide to Age-Old Asset Allocation Theory

Have you ever watched a chef cook their signature dish? It’s fascinating how they carefully pick and consider every ingredient, ensuring that each one complements the others perfectly. While I know you’re not a chef, I’m still assuming you do the same thing, Mr. John Doe, provided you even step into the kitchen. I’m just kidding, haha. Oh, by the way, I’m sure you remember Mr. Doe. You do, right? Anyway, let’s get back to what’s cooking- I mean, the secret behind the chef’s signature dish. There has to be a perfect recipe behind that signature dish of theirs, right? 

Well, did you know that just like a chef combines different ingredients in the right proportions to create a delicious meal, you can combine different asset classes in the right proportions to create a balanced investment portfolio? That’s right! Now, what exactly is asset allocation and whether it is a myth or reality? You need not worry as I, Ishita Singh, am about to clear this doubt of yours.

Let’s Understand Asset Allocation Through an Example

Let’s take a look at a short case study to understand how asset allocation works in practice. Imagine you’re a 30-year-old investor who wants to build a well-diversified portfolio that can generate stable returns over the long term. You have Rs. 100,000 to invest, and you decide to allocate it in the following way:

– 60% in mutual funds: You invest Rs. 60,000 in a mix of large-cap, mid-cap, and small-cap funds to diversify your equity exposure.

– 30% in bonds: You invest Rs. 30,000 in high-quality bonds that can provide a steady income stream and protect your capital during market downturns.

– 10% in Gold: You invest Rs. 10,000 in gold to add some diversification and potentially boost your returns.

Over the next few years, your portfolio will grow to Rs. 150,000 thanks to the strong performance of your equity investments. However, in one of the years, the market experienced a sharp downturn, and your portfolio dropped by 20%. But since you had allocated 30% of your portfolio to bonds, your losses are a lot less than what you would have lost if you had invested all your money in a single asset class.

This is exactly what asset allocation is. It is a strategy for investing that aims to balance risk and reward by distributing an investment portfolio among various asset classes such as equity, fixed income, cash and cash equivalents, real estate, and so on. The idea behind this is that asset allocation helps investors reduce the impact of risk on their portfolio since each asset class has a different correlation to one another.

Do You Need Asset Allocation

I believe you are familiar with the concept of asset allocation now, but have you ever pondered whether it’s a strategy you truly need? If not, hold on. Don’t stress out; I will simplify this for you. Remember John Doe? He has 10 lakh rupees and ten years to stay in the market. So, do you think he will allocate his funds across multiple asset classes? 

Don’t think much; he will not. You must be wondering why. 

It’s pretty simple.  People typically fall for asset allocation because of its potential to generate stable returns. However, they forget to consider their financial objectives. John Doe didn’t require asset allocation as he had both investible money and time.

However, if you are still trying to decide whether you need asset allocation or not, answer this typical question: What’s the maximum period for which you can invest your money? Did you come up with a defined number? Is it for ten or more years? If yes, then your primary focus would be wealth advancement. Yep, all you have to do is invest in equity funds and take the first step towards financial success.

However, asset allocation is your lifesaver if you did not come up with a defined number and thought that you might need your invested money during your investment period. 

So, do you need asset allocation?

The Power of Time in Investments

Did you ever expect your investments to grow in a short period? I hope not. You cannot expect to accumulate a profitable corpus for retirement in five years, can you? No right! Your investments demand time.

But how much time? Well, nobody can answer this question better than you. If you know your prior financial objectives, have enough investible money or a regular source of income, and systematically plan your investments, you can conveniently figure out your time in the market. 

Although your financial objectives determine your stay in the market, the more time you give to your investments, the better they get. After all, your investment horizon, or what we call in BFC ‘anchoring,’ immensely impacts your return on investment.

Your Risk Profile Shapes Your Strategy

Remember, I asked you the maximum period for which you can invest your money? Well, if you came up with a specific number, you’re good to go! However, if you didn’t, then that’s when asset allocation upholds you, and your risk tolerance plays a significant role in allocating your investments across multiple asset classes. It influences your asset allocation strategy and helps you decide where to invest a larger portion of your funds: equity or debt.

So, if you have a high-risk profile, you are more likely to invest a major portion of your money in equity funds and take significant risks to attain better returns. Conversely, investing in debt funds that offer moderate returns is ideal if you are a risk-averse investor. Therefore, you need to plan your investment strategy according to your risk profile so that your portfolio always stays on track and only contains investments aligned with your financial objectives.

How Does Asset Allocation Work

Imagine this- you won Rs. 1,00,000 in the lottery. Now, with a monthly income of Rs. 15,000 and no immediate need for the extra cash, what’s your game plan? How will you use the money? 

You might think, “Fixed Deposits,” right? But then again, the interest rates might not be as thrilling as you hoped. What’s the alternative? Well, I presume mutual funds, as the potential for higher returns is tempting, isn’t it? Yet, there’s a little voice in your head whispering, “What if I need the money during the investment period?” That’s when asset allocation upholds you. By relying on asset allocation, you spread your funds across multiple asset classes like equity and debt, ensuring you attain expected probable returns without losing sleep over potential losses.

Risk and Return are Directly Proportional

All right, so I’m going to be straight with you- if you’re a scaredy-cat who doesn’t want to take any risks with your investments, then mutual funds are not your cup of tea. Stick to boring old FDs. The good news is that you’ll get something, but the bad news is that it’s not going to be anything exciting- basically “itna toh milega hi” par “itna hi milega.” But if you’re feeling a bit adventurous like Mr. Doe and want to spice up your investment game, then mutual funds and asset allocation are the way to go! Just remember, risk and reward are directly proportional. I know, I know, investing is already a snooze-fest, and now I’m throwing math at you, too! But trust me, it’s worth it. Investing in mutual funds is like playing the game of life. The more risks you take, the higher the potential rewards. So, are you ready to live a little and invest a little? Well, the only acceptable answer to this is a YES!

By the way, I’ve got a great tip for you. If you’re unsure about your risk tolerance level, don’t worry, I can help you out. Just head over to Prodigy Pro and check out the Know Your Risk Profile feature. It’s a quick and easy way to better understand your risk appetite.

On a Parting Note:

To conclude this long discussion, let me sum this up for you. Asset allocation theories are not for you if you can give a discreet number to your investment horizon. However, asset allocation does make sense if you can not. Always remember that asset allocation is a choice, not a compulsion. I repeat, it’s not a compulsion! And it’s important to determine your investible surplus before investing. Therefore, making a systematic investment plan and consulting a certified financial expert before making any investment decision is crucial, as he will help you comprehend your income and expenses and simplify your financial planning so your portfolio stays on track and you attain your financial objectives.

Please share your thoughts on this post by leaving a reply in the comments section. Also, check out our recent post on “ARE MUTUAL FUNDS DIY” 

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Disclaimer – This article is for educational purposes only and by no means intends to substitute expert guidance. Mutual fund investments are subject to market risks. Please read the offer document carefully before investing.