Asset Allocation and Its Importance – Types of Asset Class and Factors Affecting Asset Allocation

ASSET ALLOCATION AND ITS IMPORTANCE

Asset allocation has become a prime and gold standard in investing nationally and even internationally. Investors starting from office workers, students, professionals to HNIs in markets have adopted asset allocation as one of their primary investment strategies. In this article, we will discuss and gain a deeper understanding of asset allocation and discuss why it is so important in the modern investing age. 

WHAT IS ASSET ALLOCATION?

Asset Allocation can be termed as an investment strategy that aims to balance the ratio of risk-reward by dividing an investment portfolio among different types of asset classes such as fixed income, real estate, equities among others. The rationale is that asset allocation assists the investor to lessen the impact of risk their portfolio carries as every class has a different correlation to others. 

TYPES OF ASSET CLASS

1. Cash and Cash Equivalents:

This includes the cash you keep in your savings account and current accounts. These are said to be low-risk low return investments. Their main feature is their liquidity. However, this comes at a cost of lower interest rates.

2. Fixed Income and Bond Investments:

These include bonds, fixed deposits, money market instruments, and certificates of deposit. They are highly popular in India as they give a guaranteed payment at maturity along with the invested amount. These instruments earn through fixed or floating interest rates, thus making them more stable than equity and hence said to be of low to moderate risk. They come clubbed with moderate expected returns.

3. Real Estate or Tangible Assets:

Tangible/Physical assets are the assets owned in the form of commercial space, land, industrial space, or real estate. They can offer good returns in the long run and are a hedge against inflation. However, they are the most illiquid of assets. This asset class should only be considered for investments once a liquid portfolio is available to meet exigencies. In case of a distress sale, transaction costs can be very high.

4. Equities or Stocks:

Shares or stocks represent ownership of an entity. If you are holding stocks of a company, you are considered a part-owner of it to the extent of your holdings. Even though this is a highly volatile asset class in the short term, they have proven to be amongst the best investment options for the long term. Equities are generally considered high-risk - high-return investments.

5. Others:

The asset classes mentioned above are the more traditional investment options. Apart from these, there are a number of other asset classes that can be used for investment purposes. Some of the other popular ones are:

• Currencies
• Commodities - Such as gold, silver and many others
• Venture Capital
• Hedge Funds
• Financial Derivatives - futures/options/swaps
• Cryptocurrencies

FACTORS AFFECTING ASSET ALLOCATION

1. Risk vs Returns:

Risk and returns go hand in hand when it comes to investing. All classes of assets have some risks associated with them. The reward for undertaking risk results in the potential of gaining high returns. So the allocation will be affected if investors want to generate high returns or want to invest safely.

2. Tenure:

Tenure is the number of years or months an investor is looking forward to investing to accomplish a specific goal. Different investment tenures inculcate different risk tolerance. For example, a long-term investment tenure might prompt an investor to invest in a higher-risk portfolio as the high volatilities and slow economic cycles in the market tend to go away with time. 

3. Risk Appetite:

Risk appetite refers to an investor's ability and willingness to lose some or all of their principal amount in anticipation of high potential returns. Aggressive investors are likely to risk most of their investments to get better returns. On the other side, conservative investors are likely to invest in securities that preserve their principal.

IMPORTANCE OF ASSET ALLOCATION

Asset allocation assists investors in various aspects which makes it very important especially in the modern age as more and more investors are becoming aware of the technicalities and rationale behind investing. 

Some of the highlights are:

1. Lower portfolio volatility:

While every asset class possesses its risks and rewards, diversifying the investments also dilutes the volatility. For instance, investing in equity and debt will protect the portfolio from experiencing the impact of a dip in any unique asset class. Both markets will deliver different results. Since each is prone to a distinct set of market trends and challenges, their performance differs. 

2. Risk Diversification:

Asset allocation diversifies the risk exposure significantly. A diverse portfolio is a mix of different market reactions at the time of an event. 

For instance, in the 2008 and 2020 market crashes, the equity sectors were drastically affected. On the other side, gold, a very popular asset performed fiscally better, delivering profits to the commodity holders. Being spread across these assets would have reduced the portfolio volatility considerably. 

3. Discipline:

When investors diversify their investments across assets, as a rule, they are teaching strong discipline and avoiding random and instant gratification. Asset allocation ensures the investor is not under-invested or over-invested in one particular area. 

4. Stable returns:

It ensures that investors get stable returns over time. For instance, say Madhu wants to invest his savings of Rs. 5 lacs for a tenure of 5 years. Based on his ZFunds financial expert’s advice, he can divide and have a mix of 25% each for equity, gild, debt, and liquid fund which he rebalances each year. 

This ensures that the exposure to risk is proportionally diversified, and over 5 years, Madhu gets stable returns on the invested funds. 

THE CRUX

Asset allocation is one of the most significant decisions that an investor will make for their future. By choosing the right blend of bonds, stocks, cash and equivalents among other asset classes can ensure that investors are set up to accomplish their financial goals. For more information and expert financial advice, you can get in touch with ZFunds and plan to achieve your financial goals.