Importance of Asset Allocation in Mutual Funds

Published On: 22-May-2019

Historical data suggests that no asset class has been consistently a winner always. As such, having an optimum asset allocation is your key to long term wealth creation, as it allows the portfolio to perform across the market trends and economic cycles. Different asset classes pass through their respective economic cycles and may even react differently to the same situations.
 

Role of Asset Allocation in Mutual Funds

 

The table below shows the historical returns of Equity, Debt, and Gold over the last ten years:

Year

Equity

Debt

Gold

2008

-55.9%

9.1%

26.6%

2009

90.9%

3.5%

24.3%

2010

17.8%

5.0%

23.2%

2011

-26.0%

6.9%

31.8%

2012

33.2%

9.4%

12.3%

2013

6.1%

3.8%

-4.5%

2014

37.4%

14.31%

-7.9%

2015

-0.2%

8.6%

-6.7%

2016

5.4%

12.9%

11.4%

2017

35.0%

4.7%

5.1%

2018

1.4%

5.9%

7.5%

 

Source: Equity - S&P BSE 200, Debt - CRISIL Composite Bond Index, Gold – Gold prices in INR  

As such, a portfolio spread over different asset classes can help you earn better returns in the long term, as it is not dependent on a single asset class and thus is better equipped to be benefited from the cyclical rallies. Different asset classes are also generally associated with varying profiles of risk and return expectations on account of embedded risks in different asset classes. While equities tend to be volatile, they also provide you with a potential of higher returns as well in the long run. At the same time, the debt may provide lesser returns and lend stability to the portfolio. Gold is also seen as a hedge to inflation, protecting the purchasing power of the currency.

How to determine and maintain the Optimum Asset Allocation to suit your investment style?

1. What is your risk-taking ability?

The first and the foremost step towards wealth creation is to determine your risk-taking ability. If you cannot take higher volatility in your portfolio, the equity allocation must be lesser, since equities tend to be volatile over the short term. Similarly, a higher debt allocation can keep you happy amidst lower volatility, albeit with lower returns. As such, it is vital for you to figure out if you are an aggressive investor or a conservative investor.

2. Determining your optimal asset allocation

Once you have figured out your risk profile, you must discuss the optimum asset allocation mix with your financial advisor and make the investments accordingly. If you are an aggressive investor, there will be a high proportion of equities in your portfolio and vice versa. Similarly, conservative investors will have a higher proportion of fixed income securities in their investment portfolio.

3. Periodic Rebalancing of the Portfolio

Once you have made the investments as per the decided asset allocation mix, you may consider the job done. However, do not consider it as a one-time decision, as you must dynamically manage the asset allocation. The portfolio performance tends to skew the asset allocation in favour of the asset class, which has performed better than the other asset class.

4. Review of Asset Allocation

The risk profile tends to change with changing financial priorities, financial goals and the growing age. As such, you should periodically review your optimum asset allocation mix. You may also consult your financial advisor to help you in this process. It needs to be acknowledged that as people grow old, even an aggressive investor tends to shift towards conservative profile, as the risk-taking ability decreases.

 

As asset allocation aims to strike a balance between risk and rewards, it can be the key to long term wealth creation for you.