"Don't put all your eggs in one basket," says an old English proverb. It suggests that one should not focus all of one's resources in one location. When viewed through the lens of personal finance, it is also an important lesson.
Consider two individuals: Ramesh and Suresh. Both earn the same amount of money, but Ramesh spends most of it on consumption and property investments. With his savings, he purchased a flat and a plot of land. Suresh has adopted an unusual approach to investing. Rather than focusing primarily on real estate, he has invested the majority of his savings in financial instruments such as equities and debt. The outcomes of the opposing decisions will be known in due course.
Most Indian investors, like Ramesh, concentrate their capital on a single asset, with real estate and gold being the most popular. Those who choose financial assets such as stocks and bonds invest excessively in a particular asset class. Portfolios composed primarily of equity mutual funds or fixed deposits are widespread.
However, in order to receive the best returns on your investments, you must diversify your investments across multiple asset classes.
What exactly is asset allocation?
People invest with a certain financial aim in mind. Returns, risk, and liquidity are the three main components of an investment, and they are all interrelated.
The balancing of these three components through investment across assets such as equity, debt, and gold to attain a financial goal is known as strategic asset allocation. It is basically a hedging strategy that allows you to offset risks from one asset by investing in other ones.
Diversification is a fundamental principle of a good asset allocation strategy, yet it may not produce the desired benefits. Diversification at random may possibly do more harm than good! You must manage your investments across assets so that their movements do not parallel one another.
Essentially, the correlation between different asset classes must be considered. For example, when the economy is strong, corporations report record profits and the value of their stock rises. However, gold has a negative connection with equities, and as stocks rise, the value of gold rises moderately. When equities surged more than 35% in 2017, gold returned roughly 5%. You can better control market risks and increase profits by investing in numerous assets.
How do you develop an asset allocation strategy?
The basic goal of asset allocation is to maximise returns while minimising risk. When selecting how much to contribute to each asset class, keep your age, risk tolerance, and investing horizon in mind.
The proportion of investment in each asset class is heavily influenced by age. When you are young, you have the luxury of giving your investments time to recover in the event of a loss. Furthermore, because the original investment value is usually small, the recovery is faster. For example, recovering a 5% loss on Rs. 1 lakh will take less time than recovering a 5% loss on Rs. 1 Cr.
As a result, as you get older, it's a good idea to shift a larger amount of your investments to safer assets like debt.
According to the investment rule of thumb, equity exposure should be 100 minus your age. So, a 40-year-old investor should ideally have 60% of his total investments in equities, but a 30-year-old investor can afford to have more than 70% of his investment in shares, 25% in borrowed assets, and the remainder in gold.
It is not, however, a universal rule, and an individual's portfolio should reflect his risk profile as well.
How should this asset allocation approach be implemented?
You've selected how much money to put into each asset class, and now it's time to put it all together. But how do you go about doing this?
If you already have mutual fund investments but just in equities funds, you can establish a SIP in debt funds. However, keep in mind that debt funds are risky, so choose one according to your risk tolerance.
You might also choose to invest in hybrid mutual funds. These funds put money into both equity and debt funds. As a result, you get both asset types in one fund. Hybrid mutual funds are also a fantastic alternative for first-time investors because they eliminate the need to purchase numerous funds. You can also consider investing in asset allocator funds.
Bottomline
While it is easy to get misled and put all of your money into one asset class, you should diversify your investments among asset classes. This guarantees that you have a portfolio that provides strong long-term returns without experiencing dramatic ups and downs along the way. Always read the scheme documents carefully before investing in any asset class, and understand the market risks that are associated with it.
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