Asset allocation stabilities your risk and reward by allocating your assets as per your financial goals, risk appetite, and investment period. The strategy involves investing your money across asset classes in varying proportions. Typically, there are three primary asset classes – equities, bonds, and cash equivalents. However, investment portfolios can also comprise alternative assets, such as real estate, commodities, art, derivatives, etc. Each asset class has a different level of risk and return and is categorized by its behaviour over time.
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What is Asset Allocation?
Benefits of Asset Allocation
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Benefits/ features of Asset Allocation:
- Diversification reduces risk: A diversified portfolio will be exposed to lower investment risk because each asset category will respond differently as the market fluctuates. Such a portfolio includes risky and non-risky assets. This minimises the risk of loss from investing in only a single asset class.
- Optimal returns: Diversification of the portfolio provides an opportunity to earn returns from the other assets when one category is not performing well. Not all the asset categories perform well at the same time. This is what makes it important to choose multiple categories of mutual funds — example, large cap, value style and so forth —, to allocate funds efficiently even within the same class.
- Eliminates timing the markets: The markets’ cycles keep changing. So, it is stressful and difficult to keep a track of individual performances of various categories to time an investor’s entry and exit. Investing in mutual funds with proper asset allocation induces a disciplined approach to investing and, hence, eliminates the risky approach of timing the market.
- Addresses liquidity needs: Optimal asset allocation ensures that investors can address their liquidity needs as and when required. Some investments have a lock-in period and that prevents access to funds during emergencies. But with asset allocation, investors can easily liquidate other funds.
- Helps in achieving financial goals: Asset allocation, if aligned to an investor’s goals, risk-taking ability and time horizon, will guide the investor to choose the appropriate mutual funds to make investments in a disciplined manner.
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Importance of Asset Allocation
Asset allocation is a principal determinant of your investment results. Moreover, asset allocation also determines your risk level. As an investor, you can use different asset allocation strategies for your goals. For instance, if you wish to save for a new car, you might prefer allocating your funds in short-term bonds and certificates of deposits (CDs). However, if you are creating a retirement portfolio, it may be advisable to create a more return-based portfolio. You could opt for retirement accounts like an IRA (Individual Retirement Account) or invest heavily in stocks (if you are more than ten years away from retirement). Since you will have a lot of time before retirement, your portfolio will be able to ride out the short-term fluctuations. That said, if you are near retirement, ideally, your asset allocation should be more conservative and focused on capital preservation rather than high returns. There is no single solution for allocating your assets. Individual investors require individual solutions. Furthermore, if a long-term horizon is something you don’t have, don’t worry. It’s never too late to get started. It’s also never too late to give your existing portfolio a face-lift. Asset allocation is not a one-time event, it’s a life-long process of progression and fine-tuning.
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