The most crucial task that an individual has is to manage risk. Asset allocation is a key mechanism to ensure that you win in both situations, when the market slumps and when it peaks.

Asset Allocation

The most crucial task that an individual has is to manage risk. Asset allocation is a key mechanism to ensure that you win in both situations, when the market slumps and when it peaks. Asset allocation is in a certain sense synonymous with Diversification, A fundamental justification for asset allocation is the notion that different asset classes offer returns that arent perfectly correlated, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return. Therefore having a mixture of asset classes is more likely to meet your goals.

In the process of personal financial planning an individual must select assets that will generate adequate returns to meet the financial goals, and at the desired levels of risk.

Asset allocation decision is about dividing the investments between asset classes such as equities, cash and money markets equivalents, bonds, insurance, real estate, derivatives. Commodities, antiques and art, international financial instruments. Asset allocation is the single most important tool when it comes to maximizing wealth; a well diversified portfolio is pertinent to achieve ‘Best Risk – Adjusted Returns’.

Once an individual has identified these asset classes, he/she needs to know how to divide his/her investments in these asset classes. The key considerations in choosing the asset classes are the level of return and the risk. Liquidity, Taxation aspects, transaction costs and ease of investment are the other considerations. To keep it simple, some investors may prefer to look at it as balancing the downside (protection against capital loss) with upside (potential for high returns), which is not entirely correct but a useful way to look at investments. Also, research has shown that in general, people are more sensitive to losses than they are to gains of the same magnitude.

Factors for asset allocation

Risk Appetite: The degree of risk tolerance varies for different people, and depends on the following:

Stage in life: A younger person, having a safe livelihood and few dependents, has time on his/her side can take high risk while choosing a portfolio.

Net-worth: If one owns lot of assets and have few liabilities i.e. have a high net worth one can afford to take more risk as one has a cushion of assets that can safeguard one from short-term losses occurring in due to market fluctuations.

Experience with investments: If one has prior experience in investing in financial markets and one is comfortable with short-term fluctuations then one can take more risk and hence more exposure to equity/real estate.

Time Horizon: The time for which one would like to hold an investment also impacts the level of risk that one can undertake. Ideally one should break his/her investment pattern over Short, medium and long term. This will ensure that there is adequate exposure across timelines which will cater to a varied set of needs.

Investment objective: This entails deciding the purpose for which the investments are being made. Different objectives would demand that one tailor their investment portfolio to meet these goals. Objectives could be:

Retirement: Person nearing his/her retirement would want a regular stream of income from the investment, while preserving the capital value. Slightly conservative investments may be planned herein.

Children Education / Marriage: If one is looking at growth along with preservation of capital, and is investing for a goal that is very important, such as saving for ones childs education. The overall risk profile may be held at ‘Moderate’ for such needs.