What is Asset Allocation in Mutual Funds?
Last Updated : June 2, 2020, 5:26 p.m.
Asset allocation is dividing the money you wish to invest based on certain criteria. It is a very important concept and keeps one in good stead especially in troubled times. Usually, we tend to invest too much or too little in one mutual fund. There are also times when we invest in only one asset class-equity or debt and forget about the other. This leads to sub-optimal results and a bad investing experience. We have heard this cliché many times- “Don’t put all your eggs in one basket”. Asset allocation allows one to properly diversify within asset classes and mutual funds. Let us know more about this crucial concept.
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Factors That Dictate Asset Allocation
Age
What is your age when you start investing in mutual funds? Well, this might seem a very obnoxious question but has significance. Someone in his 20s should have a different asset allocation than someone in his 40s. When we are young, we have lesser responsibilities, have age on our side and can take a higher risk. So, in the 20s, one’s portfolio should be tilted more towards equities, 80-90% should be in equity mutual funds and the rest in debt. Within the 80-90% equity, one should predominantly (40-50%) invest in mid & small-cap funds which have higher growth potential. For someone in his 40s, this could be 60-70% in equity and the rest in debt. But hey age is not the only criteria to decide, let’s look at other factors.
Risk Appetite
Every individual has a different risk appetite, someone can see his investment go down by 30% and still hold his portfolio while some get sleepless nights even if it is negative by 1%. One needs to assess and know his/her risk appetite. If you are one of those who want your capital to be protected at any cost, your asset allocation should be only in safe debt funds or fixed deposits. Albeit you will have to contend with lower returns. But if you do not get perturbed and sell your investments when they go down by 30% and are willing to hold for a long period, only then you should invest in equity mutual funds. There is no standard answer to risk appetite, it varies from individual to individual basis his/her temperament and financial health.
Time Horizon
The time horizon of the investment is governed by the goals we wish to achieve. Again, every individual would have a different time horizon basis his/her goals. Mr. A wants to invest to buy a house in the next 10 years, while Mr. B wants to buy the dream car in the next 3 years. In both these cases, fund selection and asset class selection will be different. Investments in equity funds should be made only if your time horizon is a minimum of 5 years and ideally more than 10 years. For a time horizon of less than 5 years, portfolios should only have debt or hybrid funds.
When we combine the three, we can arrive at our own asset allocation and invest accordingly. This is critical since it lends the much-required balance to the portfolio. When stock markets go down, the right asset allocation in debt, which will still yield you 6-8%, will keep your portfolio afloat. Thus, before investing, one should look at each of these three factors and decide his/her mutual fund asset allocation.