What is Asset Allocation Strategy?

Published On: 06-Dec-2019

A prudent financial plan is not the one that depends upon a concentrated portfolio to generate returns over the long term. Instead, one must have a diversified portfolio across asset classes and stay on course for long term wealth creation. It is noticed that no single asset class remains a winner always, and different asset classes may be outperforming in different years. This is because different asset classes may react to similar macroeconomic changes in different ways. For example, the recent corporate tax cut in September 2019 was highly favourable for the equity markets, but debt markets reacted adversely to it, sensing higher fiscal deficit and higher Govt. borrowings. As such, having a diversified portfolio can help the investors to make the most of different asset classes. 

Asset Allocation Strategy

Generic Principle for asset allocation

Recognising the changes in risk profile as one grows older, the thumb rule for maintaining asset allocation in the portfolio can be the age factor. As such, one must invest a percentage equal to one’s age in debt instruments, while the balance can be favourable in debt markets. Further, one can also consider investing in gold, but such exposure in gold should not preferably exceed 10% of the overall portfolio. 

Importance of Asset Allocation

Making investments across different asset classes mitigates the investment risk to some extent, as the portfolio does not remain dependent on a single asset class. Further, given the cyclical nature of economic cycles across different asset classes, the investors may be benefited from diversifying their portfolio. A prudent asset allocation strategy continues to stay focused on the type (of investment), the timing of such investment and finally, the proportion of investments into various asset classes.

Further, even within the broader asset classes, one must diversify across different market segments. For example, within equities, the investors may create a portfolio spread across mid-cap, small-cap and large-cap companies to mitigate concentration risk. To achieve geographical diversification, one can also allocate a smaller portion of their portfolio into international equities. Similarly, in the universe of debt securities, one may consider investing in G-Sec funds, credit funds, banking & PSU fund, etc. 

Types of Asset Allocation

While one may have taken the right investment decision to build a diversified portfolio and allocate investments across different asset classes, not reviewing the asset allocation on a periodical basis can be harmful to portfolio health. However, before we discuss how it adversely impacts the portfolio, let us know about the types of asset allocation. One can adopt static asset allocation strategy wherein buy and hold approach is adopted. Such an investment strategy requires that the investments are made as per the optimum asset allocation. However, any changes in the asset allocation of the portfolio, due to the relative performance of the portfolio constituents may skew the portfolio in favour of such investments, which have outperformed the markets and other asset classes. Here is how the portfolio changes its composition due to portfolio performance:

Particulars

Equities

Debt

Total

Initial Investment with asset allocation 1:1

50,000

50,000

1,00,000

After one year:

Returns (If equities outperformed)

 

20%

 

10%

 

Portfolio after one year

60,000

55,000

1,15,000

Asset Allocation Ratio

1.09

1

 

After one year:

Returns (If debt outperformed)

 

5%

 

15%

 

Portfolio after one year

52,500

57,500

1,10,000

Asset Allocation Ratio

0.91

1

 
 

As against the static asset allocation, one also try to adopt a dynamic asset allocation strategy wherein the portfolio composition is decided based on relative valuations of different asset classes. Such dynamic asset allocation enables the investors to stay aligned to their financial goals and risk profiles on an ongoing basis. 

Asset allocation Funds

Given the current volatility in the equity markets, asset allocation funds be helpful for the investors, as such funds aim to adopt a suitable asset allocation strategy, depending upon the relative valuations, market conditions, and outlook. With investments spread across equity and debt, the investors render portfolio diversification to their portfolio across asset classes. Managing asset allocation dynamically through asset allocation funds be a prudent investing strategy. 

Asset allocation tends to be the key to long term wealth creation. As such, a sound asset allocation strategy be your path to financial prosperity. Make sure you choose an optimal path to achieve your financial goal.