What is Asset Allocation? Meaning, Examples, Types, Working
Investing in different classes of assets like real estate, gold, mutual funds, equities, and fixed deposits, will help you mitigate your risk and provide risk-adjusted returns. This blog will help you understand different types of assets and guide you to allocate your funds to the right kind of assets.
What Is Asset Allocation?
The term “asset allocation” describes the distribution or allocation of your funds among various asset classes, including fixed income, real estate, commodities and equity. Asset allocation’s main goal is to lower the risk involved with your investment.
Not all of your assets may probably yield comparable profits for you. Market volatility impacts certain assets that offer returns based on market performance. Therefore, investing across various asset classes can reduce the likelihood of losses and increase the possibility of generating higher returns.
Importance of Asset Allocation
- Proper asset allocation helps you attain your objectives by ensuring a consistent and growing income over time.
- Additionally it aids in mitigating risks and volatility providing you with peace of mind and facilitating adherence, to your investment strategy.
- It enables you to capitalise on market trends and earn profit
What Are the Different Types of Assets?
Assets can be broadly categorised into three classes depending on three factors. These are:
The convertibility of an asset determines how easily it can be encashed. Depending on this factor, it is further branched into two sections. These are:
- Current Assets: These assets can be easily converted into cash or cash equivalents. Investments in these assets are generally for a shorter period of time. So, these assets are also called liquid assets or short-term assets.
A few examples of current assets are cash, cash equivalents, inventory, stocks, mutual funds, pre-paid expenses, money market funds, etc.
- Fixed or Non-Current Assets: These assets cannot be easily converted into cash or cash equivalent. They usually have a lock-in period or require high transaction value or a suitable buyer.
A few examples of fixed assets are private and government securities investments with a lock-in period, real estate like land and apartments, machinery, computer equipment, etc.
An asset can be divided into two more types depending on its physical existence. These are:
- Tangible Assets: Assets which can be physically accessible are called tangible assets. These include both current and noncurrent assets which can be physically touched.
- Intangible Assets: Assets that do not have a physical existence are called intangible assets. Examples of intangible assets are NFTs, cryptocurrencies, etc.
Depending on the usage purpose, assets can be further classified into two sections. These are:
- Operating Assets: These kinds of assets are required for day-to-day purposes.
- Non-Operating Assets: These kinds of assets are not required for everyday purposes but are kept for future use.
Examples of non-operating assets are shares purchased for long-term investment, vacant land purchased for future purposes, etc.
What Are the Factors on Which Asset Allocation Depends?
The factors on which asset allocation depends are:
- Understanding your risk tolerance: Your risk tolerance can be divided into three categories:
- Your Appetite for Risk: This is measured by the level of uncertainty you are willing to accept.
- Your Capacity of Risk: This is measured by how much risk you can tolerate based on age, income, family dependency, and liabilities.
- Your Tolerance of Risk: This measures how you accept and react mentally and psychologically to the risk factors like market fluctuations which may result in losses in your investments.
- Your goals: Your financial goals must be crystal clear while investing in assets. Your portfolio of investment will vary according to your goals. Your goals can be both long-term and short-term.
For short-term goals, it’s better to invest in low-risk assets like fixed-income securities. For long-term goals, you can afford to take some risk and invest in equities.
You might want to invest in liquid assets to build an emergency fund. If you have a high-risk appetite and wish to achieve financial independence early, in that case, you should heavily invest in equities.
- Your income: If you get a fixed amount as a salary every month, you can afford to take some risk and invest in risky assets. If you don’t have a fixed source of income, it’s better to invest in assets with greater liquidity and minimal risks.
- Your age: The older you become, the less likely it becomes to take risks due to several responsibilities like family dependency and other liabilities. So if you want to take risks, it’s better to start investing at an early age when you can afford to absorb the loss If the odds are stacked against you.
What Are the Types of Investment Portfolios?
The different types of investment portfolios have been discussed below:
- Secured Portfolio: Large portions of the total investment amount are typically allocated to lower-risk securities, such as fixed-income instruments; Hence, these are also referred to as conservative model portfolios.
Protecting your portfolio’s principal value is the key objective of a secured portfolio. These models are frequently referred to as capital preservation portfolios for this reason.
Even if you are extremely cautious and inclined to completely shun the stock market, a small amount of exposure to stocks can assist in counteracting inflation. The equity part might be put into an index fund or a portfolio of reputable blue-chip corporations.
- Moderately Secured Portfolio: A moderately secured portfolio works for the investor who wants to preserve most of the portfolio’s total value but is prepared to assume some risk. This technique calls for selecting stocks that offer substantial dividends and investing in high-return debt securities that offer coupon payments.
- Moderately Risky Portfolio: Because fixed-income securities and stocks comprise about equal portions of the asset composition, moderately risky portfolios are frequently referred to as balanced portfolios.
This technique works best for investors with a long time horizon (usually 5-7 years) and a medium level of risk tolerance because moderately risky portfolios have a higher level of risk than secured portfolios.
- Risky Portfolio: Since equities make up the majority of risky portfolios, their value can vary greatly in a matter of days. If you have a risky portfolio, your major objective is to achieve long-term capital growth.
A capital growth strategy is one such approach. Investors generally include some fixed-income products to enhance diversification.
- Very Risky Portfolio: Very risky portfolios consist almost entirely of shares of companies and equity-oriented mutual funds. Here, your goal is exponential capital appreciation over a long time horizon. However, because these portfolios are highly risky, short-term returns may fluctuate consistently. Hence, it is ideal for investors with a long-term investment horizon.
What are the Benefits of Asset Allocation?
The benefits of effective asset allocation are mentioned below.
- Allocating assets across different sectors and asset types helps in portfolio diversification. Ideally, all your investments in various securities cannot go down simultaneously.
Maybe in a particular market scenario, a few of your investments will not perform well. Still, if you allocate your money across different asset classes, the rest of your investment will compensate for the loss.
- Since you are always generating passive income from your different investments, you will be ready to tackle the rising inflation costs.
- Investing in certain securities may also reduce your taxable income.
What is Multi Asset Allocation Fund?
Multi asset allocation funds are open-ended hybrid schemes that invest in at least three asset classes. Additionally, the minimum allocation for each asset has to be 10%. These funds usually invest in equities, debt instruments and other asset classes like gold, Commodity ETFs, units of REITs, InvITs, etc.
The primary aim of these hybrid funds is to leverage multiple asset classes to get the best possible returns in different market conditions. In addition, multi asset allocation funds spread the overall risk across different asset classes.
4 Effective Strategies for Asset Allocation
Age-based asset allocation:
Age-based asset allocation is a strategy where you adjust how you distribute your investments based on age. The idea behind this approach is to reduce your investment risk as you grow older.
To determine how much of your portfolio should be in stocks, a simple guideline is to subtract your age from 100. For instance, if you’re 25 years old, then 75% of your portfolio should be allocated to stocks, while the remaining 25% can go towards bonds and cash. As retirement approaches, shifting more of your investments from stocks towards fixed-income options is advisable. This helps minimise risk and safeguard the capital you’ve accumulated over the years.
Strategic Asset Allocation:
Strategic asset allocation is a long-term investment strategy that divides your portfolio into different asset classes, such as stocks, bonds and cash. The main aim of strategic asset allocation is to minimise risk and increase the likelihood of achieving your objectives.
When implementing strategic asset allocation, you establish a fixed allocation mix for your assets, meaning that you maintain the percentage of your portfolio invested in each asset category over time. To ensure your investments align with the principle of strategic asset allocation, it’s important to rebalance your portfolio.
Tactical Asset Allocation:
Tactical asset allocation is a dynamic investment strategy that involves adjusting your asset allocation based on market conditions. With tactical asset allocation, you might increase your stock allocation if you believe the market is undervalued and decrease it if you think it’s overvalued.
Implementing tactical asset allocation requires expertise in timing the market and analysing investments.
For example, consider if your strategic asset allocation recommends maintaining 70% equity and 30% debt holdings. However, during a specific period, you have reason to believe that equities have the potential for short-term high returns.
In this scenario, you might consider temporarily increasing your stock investment to 80% and adjusting it when you feel that stock valuations have become unreasonably high. Adding an extra 10% to stocks can potentially boost your returns in the short term. In Tactical Asset Allocation, it’s important to recognise when the short-term opportunity has peaked and quickly readjust to your target long-term investment plan.
Dynamic Asset Allocation
Dynamic asset allocation refers to the practice of adjusting your investment portfolio’s asset allocation mix based on prevailing market conditions. This approach involves closely monitoring the market and making changes to your portfolio. Dynamic asset allocation necessitates an in-depth comprehension of market trends and a high level of investment expertise.
Comparison of Tactical and Dynamic Asset Allocation
The main difference between tactical asset allocation and dynamic asset allocation is the frequency of changes to your asset allocation. With tactical asset allocation, you make changes to your asset allocation on a short-term basis. In contrast, with dynamic asset allocation, you make changes to your asset allocation on a continuous basis.
Which Strategy is Right for You?
Your best asset allocation strategy will depend on your circumstances and risk tolerance. A static asset allocation might be a better option if you are a risk-averse investor. However, if you are a more aggressive investor and you are willing to take on more risk, then a tactical or dynamic asset allocation might be a better option for you.
Strategic asset allocation enables investors to increase their risk-adjusted returns while lowering risk. The various asset allocation strategies that were just discussed above accommodate a variety of investment objectives as well as different risk appetites and time horizons.
When you’ve determined which asset allocation approach is best for you, keep in mind that you should frequently examine your portfolio to ensure you’re maintaining your allocation and staying on course to achieve your financial objectives.
Why is asset allocation important?
Asset allocation is important because it can help manage risk and maximise returns in your investment portfolio. A well-diversified portfolio can help mitigate the impact of market volatility and increase the likelihood of achieving your financial goals.
What are the different asset classes?
The main asset classes are stocks (equities), bonds (fixed income), cash and cash equivalents, and alternative investments such as real estate, commodities, and hedge funds.
How do I determine my asset allocation?
Your asset allocation depends on several factors including your investment goals, risk tolerance, time horizon, and financial situation. It’s important to work with a financial advisor or use online tools to determine the appropriate asset allocation for your needs.
What is the difference between strategic and tactical asset allocation?
Strategic asset allocation involves establishing a long-term investment plan and sticking to it, while tactical asset allocation involves making adjustments to your portfolio based on short-term market conditions.
What is the formula of asset allocation?
The rule of 100 is a guideline that helps determine the proportion of your investment portfolio that should be allocated to stocks. To apply this rule subtract your age from 100. The resulting number represents the percentage of your portfolio that you should consider investing in stocks. For instance if you’re 40 years old it is recommended to invest, around 60% of your portfolio in stocks.
This principle is based on the notion that younger investors can take risks since they have time to recover from any potential losses. As investors age they should gradually decrease their exposure to risk and increase their allocation towards fixed return investments like bonds..
What is asset allocation vs diversification?
Diversification focuses on the details. When it comes to your investment portfolio asset allocation determines the proportion of each asset class you should invest in while diversification determines the securities, within each asset class.
Both asset allocation and diversification play roles in minimising risk and achieving your objectives. However asset allocation is generally deemed crucial than diversification. This is because asset allocation holds sway, over your portfolios risk and potential returns.