Asset Allocation Is The Most Important Parameter In Backing The Overall Portfolio Return

Ajay Kumar Yadav,
CFPCM, CEO & CIO, Wise Finserv Pvt. Ltd.




Ajay Kumar Yadav, 
CFPCM, CEO & CIO, Wise Finserv Pvt. Ltd.

Asset allocation is one of the most important decisions that investors make while making investments. Allocating your investments among different asset classes is a key strategy to minimize risk and potentially increase gains. Asset allocation involves dividing your investment portfolio across various asset classes like equity including any other equity-related instruments, bonds/debt mutual funds and money market securities. Essentially, asset allocation is an organised and effective method of diversification.

There is no thumb rule for asset allocation, but many have been following 100 minus age concept. According to this concept, individuals should hold a percentage of equity investment equal to 100 minus their age. So, for a typical 60-year-old, 40% of the portfolio should be in equity-related instruments and rest would be comprised of high-grade bonds/debt mutual funds, and other relatively safe assets.

The investment options for asset allocation typically fall within three classes: equity mutual funds/equity stocks; debt mutual funds/other debt securities funds/bonds and cash. The main goal of allocating your assets is to minimize risk while meeting an expected level of return. Of course, to maximize return and minimize risk, you need to know the risk-return characteristics of the various asset classes.

Equities have the highest potential return, but also the highest risk. On the other hand, debt investment asset class has the lowest risk, but it provides the lowest potential return. Keep in mind that high-risk choices are better suited for investors who have a high risk tolerance (can accept wide fluctuations in value) and who have a longer time horizon to recover from losses.

It is because of the risk-return trade-off that the potential return rises with an increase in risk – that’s why diversification through asset allocation is important. Since different assets have different risks and market fluctuations, proper asset allocation insulates your entire portfolio from the ups and downs of one single class of securities. So, while part of your portfolio may contain more volatile securities – which you've chosen for their potential of earning higher returns – the other part of your portfolio devoted to other assets remains stable

As each asset class has varying levels of return and risk, investors should consider their risk tolerance, investment objectives, time horizon and available capital as the basis for their asset composition. Investors with a long time horizon and larger sums to invest may feel more comfortable with high-risk, high-return options. In contrast, investors with smaller sums and shorter time spans may feel more comfortable with low-risk, low-return allocations.

To make the asset allocation process easier for clients, many investment advisory companies create a series of model portfolios, each comprising different proportions of asset classes.

Conservative Portfolios : Conservative model portfolios generally allocate a large percentage of the total portfolio to lower-risk securities such as fixed-income and money market securities. The main goal of a conservative portfolio is to protect the principal value of your portfolio. As such, these models are often referred to as "capital preservation portfolios."

Moderately Conservative Portfolios : A moderately conservative portfolio is ideal for those who wish to preserve a large portion of the portfolio's total value, but are willing to take on a higher amount of risk to get some inflation protection.

Balanced Portfolios : In balanced model portfolios, the asset composition is divided almost equally between fixed-income securities and equities in order to provide a balance of growth and income. This strategy is best for investors with a longer time horizon (generally more than five years) and a medium level of risk tolerance.

Very Aggressive Portfolios : Very aggressive portfolios consist almost entirely of equities. Your main goal is aggressive capital growth over a long time horizon. Since these portfolios carry a considerable amount of risk, the value of the portfolio will vary widely in the short term.

The different asset allocation strategies described above cover a wide range of investment styles, accommodating varying risk tolerance, time frames and goals. Once you have chosen an appropriate asset allocation strategy, remember to conduct periodic reviews of your portfolio to ensure you are maintaining your intended allocation and are still on track to your long-term investment goals.

The writer is a CEO & CIO, Wise Finserv Pvt. Ltd.
Website: www.wisefinserv.com