Various asset classes like equity, debt, or gold have different levels of risk and return. Due to this, they behave differently over time. So, to balance the risk and reward in your portfolio, use any asset allocation strategy.
What Are the Factors That Affect Asset Allocation?
Asset classes are allocated in the portfolio based on the investor’s financial goals, risk profile, and investment terms. What can affect your asset allocation as an investor? Let’s find out.
Your investment goals decide the allocation of your assets. Whether your goal is short term and immediate, like an exotic holiday, or a long-term investment like retirement planning, it will directly affect the asset class you pick.
Your risk profile reflects your risk appetite. When you are younger, your risk appetite will be at its peak, as you have plenty of years ahead to earn and cover up the losses. Gradually, as you age, you need to protect your capital due to unforeseen responsibilities.
The investment tenure plays a crucial role in prudent asset allocation. If it’s long-term investing, you can give your funds to equity and real estate. This is because, returns will play a significant role in enhancing your portfolio over the long run. Whereas, if your goals are short term, you should go for debt or other secure avenues. In the short term, markets can be volatile. Therefore, going for fast and fixed return instruments ensures the protection of your invested capital.
How Asset Allocation Works
After you choose the asset classes, you need to divide your investments proportionately.
For instance, if you want to buy a car next year, you should primarily invest in debt instruments like liquid funds or short-term bonds. You should avoid investing in equity or real estate as long-term investments with higher risk profiles. This will ensure the safety of the capital invested. Therefore, you can allocate your assets into fixed deposits, bonds, and fixed income instruments.
Asset Allocation Strategies
Still confused on how to choose the right asset class? Let’s discuss a few asset-allocation strategies that can help you.
Constant Weight Asset Allocation:
This strategy focuses on rebalancing your asset. The investor constantly rebalances the portfolio through buying and selling. For instance, if the portfolio consists of 60% equity, 25% US stocks, and 15% debt, if there is an increase in the equity value, the investor will sell off a portion of the equity to maintain the proportion of each asset class.
Strategic Asset Allocation:
Here, the investor sets the allocations for different asset classes. The portfolio is rebalanced accordingly. The targets depend upon the investor’s risk appetite, goals of investing, time horizon, etc.
Dynamic Asset Allocation:
Here, the portfolio is adjusted to suit the market conditions. This involves reducing the proportion of the worst asset class and increasing the ratio of the best-performing asset in the portfolio. With this strategy, the investors ensure that they hold some of the best-performing, diversified assets to reduce risk.
Age-Based Asset Allocation:
This strategy ensures that your portfolio is adjusted according to your age. The thumb rule is that the weight of your equity allocation should be 100 minus your age. Therefore, if your current age is 25, your portfolio’s equity allocation should be 75% (100–25). As you reach 40, the equity portion in your portfolio should reduce to 60% (100–40).
Tactical Asset Allocation:
This strategy involves constantly adjusting the portfolio to take advantage of the economic situation and the market conditions. The cash, bonds, stocks, etc., are changed according to the macroeconomic situations.
Life Cycle Funds Asset Allocation:
This strategy is ideally suited for retirement planning. In this strategy, the funds in each asset class are adjusted to reduce the risk as retirement approaches. This implies reducing the riskier asset class while increasing the more secure asset class share.
Insured Asset Allocation:
This strategy is ideally suited for risk-averse investors. In this strategy, investors set a base value beyond which the portfolio value shall not drop. If the asset value falls below the set value, the investor takes action to avert the risk.
Asset Allocation In A Nutshell
Remember, diversification is the key to successful investing. Including multiple asset classes in the portfolio helps investors reduce the overall portfolio risk. Don’t forget to periodically review and adjust your portfolio to attain your financial goals. What is your asset allocation strategy? Tell us in the comment section.
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