- Optimal asset allocation based on financial goals, risk-tolerance, time horizon can lead to a rewarding future
- People with Greater risk-tolerance, long time horizon should invest more in equity funds
- Debt funds are suitable for Investors with low-risk appetite and short investment horizon
Asset allocation is the implementation of an investment strategy which aims to create a balance between the risk and the return i.e. allotting the money to various categories depending upon the risk appetite of the investor.
The primary aim of asset allocation is to reduce the market volatility (ups and downs of the market) and create maximum wealth for the investors.
The above statement can also be explained with the help of an example:
Investor A is of 30 years of age and is an aggressive investor, asset allocation for investor A would be 80-85% in equity, 10% in debt and remaining in others.
Investor B is 50 years of age and considers himself a conservative investor. His asset allocation would be 70-80% in debt funds 5-10% in equity and remaining in others.
Factors Affecting the Asset Allocation for an Investor
The process of determining an optimal mix of assets for your portfolio is personal choice an investor has to make. The factors that will suit your goal planning at any given point primarily depends on the time horizon and the ability to take a risk.
Time Horizon: It is defined as the duration (days, months, years, decades) for which the investor would be investing to achieve a particular financial goal. An aggressive investor with decent vintage in the markets has higher chances of generating good returns vis a vis an investor who has just started investing in the market.
Risk Tolerance: Risk can be defined as the difference between the potential returns and the actual returns. Whereas risk tolerance can be termed as the ability and willingness of an investor to lose some or all the money in exchange for greater potential returns. An aggressive investor or the one with high-risk tolerance has a higher chance of losing money in exchange for greater potential returns as compared to a conservative investor or the one with low-risk tolerance. In the words of the popular saying, conservative investors keep a “bird in the hand,” while aggressive investors seek “two in the bush.”
Benefits That Can be Reaped from Optimal Asset Allocation
Optimal Return – Proper asset allocation helps to determine how much return one can expect from their potential investments taking into consideration the amount of risk involved. In the absence of appropriate asset allocation, an investor ends up investing on ad-hoc basis and might end up in a position where the financial goals are not met.
Risk Minimization – Choosing the best suited asset allocation determines the risk tolerance of an investor. An avid investor who has generated decent returns in the past might be willing to take a greater amount of risk. Whereas an investor who has burnt his fingers in the past would be more willing to go for fixed income funds.
Aligning Investments with Time horizon – The time horizon plays a key role in determining the apt allocation. The golden rule to generate good returns is to stay invested for a longer duration. Longer the time horizon of financial goals more flexible is the asset allocation. In case of a long-time horizon, an investor can tilt towards equities. Whereas equities are considered very risky in the short term.
Minimizing Taxes – If an investor happens to be under 30% tax bracket and invest all their savings in fixed deposit to keep your investments safe, then he is making a big mistake by paying a huge amount in taxes, which otherwise could have been legitimately saved. Tax consequences are different for every individual and every scenario. And so, you should always view investment returns from the point of post-tax returns on investments rather than pre-tax returns. Proper asset allocation will not only help you to determine the right asset class, but also the right investment product which will help you to minimize taxes.
Adequate Liquidity – Liquidity is also one of the vital factors while making an investment decision as some investments have a lock-in period and can’t be redeemed within that period. For example, if you are investing in a Public Provident Fund (PPF)account or Equity Linked Saving Scheme (ELSS) mutual fund and need money in next 1 year, then they aren’t the right investments for you no matter how good these investments are. Prudent asset allocation will make sure that you have sufficient liquidity to pay for your financial goals as and when required.
Achieving an ideal asset allocation position is not an end by itself. Change in goals can alter the asset allocation. For example, when one nears a goal, it is better to move to safer assets like debt. Similarly, time can also bring about a need for change in asset allocation. Risk capacity and risk tolerance can change over time. Also, as one becomes old, there is usually a preference to move away from volatile assets to safer avenues. Hence reviewing the asset allocation position and re-aligning when needed is absolutely necessary.
The writer of this post is Mr Nikhil Sapra, he is a team leader in Mutual Funds division at Wishfin
Disclaimer – “Mutual fund investments are subject to market risks. Please read the scheme document carefully before investing”.