The adage 'don't put all your eggs in one basket' is relevant to a lot of aspects of life, including your hard-earned savings. The advice, first cited by Miguel Cervantes 500 years ago, has stood the test of time and is considered one of the fundamental pillars for generating long-term wealth.
Before we dive into the importance of asset allocation, let's first understand what it is. Essentially, asset allocation is about dividing your investment portfolio into different asset categories such as stocks, fixed income, mutual funds, cash, gold, forex, real estate, etc. so as to balance the inherent investment risks, while focusing on growth.
For example, equity investments are considered high risk and high return instruments, while fixed income or debt funds are on the other end of the spectrum with low to medium risk.
Conversely, gold is viewed as an option that can help balance volatility from other asset classes. Similarly, forex denominated investments are intended to mitigate the risk of local currency depreciation, as well as to provide you with an opportunity to invest in global markets.
While risk is an important factor in asset allocation, the relative proportion of each asset class also depends on your financial goals, investment horizon, as well as other factors such as liquidity and tax optimisation.
Benefits of asset allocation
Asset allocation is a crucial step in long-term wealth creation. Firstly, it helps minimise risk arising from the fluctuations in the value of the underlying asset class. Changes in the economy and market fluctuations impact asset classes differently.
An asset allocation strategy encourages diversification of your investment choices and helps in minimising risk to your portfolio. That said, do note that your ability to take risk is fundamentally different from your desire to take risk. A good wealth manager can differentiate between the two and create an asset allocation plan suited to your needs.
Secondly, it encourages long-term investing. Time plays a critical role in compounding wealth. Asset allocation ensures that you are investing in a disciplined manner as per your goals. Studies suggest that investors who follow a structured and consistent asset allocation strategy make significantly larger gains over the long-term (10 year+) as compared to investors who make arbitrary investment decisions.
Asset allocation strategies you can adopt
Every investor has a different path to wealth creation, and hence, the asset allocation strategy will differ too as long as it reflects the investor's goals, risk appetite, and investment horizon. Let's take a look at some popular approaches.
Life-stage allocation strategy: With the assumption that people usually have a greater appetite for risk at a younger age, you can consider investing in inflation-beating growth assets. Equity is the primary asset class when it comes to building wealth over the long term (7-10 years) due to its ability to stay ahead of inflation. The primary way to invest in this asset class for starters would be through equity mutual funds. You can add direct stocks and ETFs depending on your specific needs.
As you come closer to your retirement, your asset allocation should have an increasing mix of debt and fixed income products. However, remember that you should not completely liquidate all your equity investments, as your equity portfolio is required to combat inflation even post-retirement.
Goal-based strategy: With this strategy, your financial goals decide your individual asset allocation. For example, the strategy for a retirement goal that is 30 years away will be very different from a medium-term goal to buy a house within seven years, or a short-term goal for an international vacation less than a year away.
This kind of an approach is more personal and dynamic in nature, as it's based on your personal needs, as opposed to some age-old thumb rule.
Affluence-based strategy: This asset allocation strategy assumes that the inherent risk profile of an investor is aligned to the affluence stage of the investor. If you are more affluent with a reasonable corpus parked away for emergencies, your ability to take risk on part of your portfolio is higher. It also bolsters your ability to absorb large market corrections without compromising your lifestyle or outlook towards the future.
Shifting gears to a conservative strategy may not appeal to you just because you're getting older, and vice-versa. This kind of approach requires strong assistance from an experienced expert who can build a contextual asset allocation and help with the relevant curation of investment options.
Getting on track for wealth generation
Asset allocation is a significant part of one's long-term financial plan and its role in wealth generation should not be overlooked. Through an appropriate asset allocation strategy, investors can optimise the risks of their investment portfolio and fulfill their wealth creation needs.
That said, trying to figure out inherent risk-tolerance can be challenging, as it affects how one should invest and diversify. A good wealth manager can help you create an asset allocation plan that sets a prudent path to compounding wealth, preserving assets and securing your peace of mind.
(The author is Co-Founder and CBO, Scripbox.)
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