Investor portfolios - Asset allocation key to achieving goals
1/25/2012 8:28 PM Wednesday
By - Hemant Rustagi
CEO, Wiseinvest Advisors
It is quite common to see investors putting in money without determining their investment goals and deciding the right asset allocation. As they focus mainly on performance, other important aspects of portfolio building such as diversification and asset allocation do not get due attention. However, the fact is that asset allocation not only reduces risk but also helps in optimising returns on a risk-adjusted basis.
If you want to be a successful investor, you must first decide the asset allocation and only then select investment options. Asset allocation is an investment strategy that allows an investor to choose among various asset classes such as equities, debt, real estate and commodities. Simply put, asset allocation as a method of investing is an integral part of an investor’s financial planning process. The asset allocation strategy that can work the best for you would largely depend upon your risk tolerance and time horizon.
Risk tolerance is your ability and willingness to take risks in order to achieve higher potential returns. Therefore, if you have high risk tolerance, you will have the capacity to take market volatility in your stride to enhance your chances of earning higher returns. On the other hand, if you are a conservative investor, you would prefer investment options that will preserve your capital.
Time horizon is the expected number of years you are likely to remain invested to achieve an investment objective. If you intend to invest for a longer time horizon, you would generally have the capacity to invest in riskier or more volatile asset classes, as you can wait out the inevitable ups and downs of the markets. On the other hand, if you intend to invest to achieve a short-term goal, you are likely to have lesser appetite for risk-taking.
Besides these considerations, you also need to be aware of the different risks associated with investments. Some of these are:
- Market Risk - Market risk is the risk of the portfolio value falling due to fluctuations in the prices of securities. Diversification helps in managing risk in the portfolio. There are different ways to diversify a portfolio, such as investing across different asset classes, sectors, market capitalisations and geographies. Another important strategy for managing risk is to rebalance the portfolio periodically. This helps an investor in buying low and selling high in a disciplined manner.
- Inflation Risk - Inflation risk is the risk of losses resulting from erosion of income or the value of assets due to the rising costs of goods and services. It is among the major risks for those who mainly invest in debt and debt-related securities.
- Longevity Risk - Investors may outlive their assets. Hence, it is absolutely necessary to design a portfolio that has the potential to provide a positive real rate of return over time.
- Behavioural Risk - It is a well-known fact that uncertainty is a natural part of investing. However, many investors do not act in their own best interests when faced with uncertainty. This has a substantial impact on their investment results in the long run. Therefore, the key is to stick to one’s investment plan, irrespective of the market conditions.
- Sequence Risk - Although having a financial plan and following it in a disciplined manner helps, one may still have the misfortune of experiencing a market downturn just around the completion of one’s time horizon. Therefore, it pays to start protecting gains by scheduling the asset allocation for long-term goals in a phased manner, say around 12-18 months before the target date.
Finally, remember that a successful asset allocation strategy requires the commitment to keep a designated percentage of assets invested in their respective classes, regardless of the current performance of those classes.
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