As they say, never put all your eggs in one basket. Suppose you do so; there is a chance that when the basket falls, all your saved eggs will be gone, and you will get nothing. But if you had kept all the eggs in different baskets, you could have saved a few of them. Analogous to the example of the eggs, diversification is essential when we plan our investments.
Asset allocation distributes your investments across available asset classes such as equity, debt, gold, real estate or holding cash. Asset allocation is based on factors such as your financial goal, risk appetite, and financial conditions, which change over time. Simply put, asset allocation is similar to a buffet dinner where a variety of tempting dishes are available, and you need to help yourself with some of them, depending on your tastes. By allocating your assets, you essentially adopt an investment strategy that balances your portfolio’s risk and reward.
The first step towards asset allocation is setting your goal, examining your finances and understanding risk tolerance. Investors can engage with a financial planner to undertake risk profiling tests that accurately capture their risk appetite. The next step is to be aware of one’s financial commitments and then arrive at the investment required to meet financial goals.
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Benefits of Asset Allocation
- Optimal returns: Many investors are investing impromptu. Some investors are very conservative, and some are very aggressive, so they invest accordingly. As a result, they may not earn adequate risk-adjusted results on their investments. The right asset allocation will help provide efficient returns as investments will be diversified.
- Minimize risk: While each asset class has its own risk and return. When you diversify your investment, it minimizes volatility. Asset allocation ensures that your portfolio risk is spread over various asset classes.
- Lower stress: Spreading investment across various asset classes provides a cushion during a volatile market. Which ultimately keeps your stress lower as an investor. Proper asset allocation helps investors cope with volatility or loss better.
To help you better understand why asset allocation matters, let us look at the annual returns for different asset classes in 2018 and 2023.
As evident from the above graphs, asset returns exhibit significant fluctuations annually. Some assets yield higher returns in one year, whereas others outperform in other periods. As seen in the above charts, small caps and mid-caps delivered negative returns in 2018, where gold delivered the highest return in the calendar year amongst all the asset classes. On the other hand, mid-caps and small caps were the top performers in 2023, where gold was at the fourth rank. So, if an investor invests only in one asset class, he risks losing his returns.
Consider two examples to understand this better:
- An individual solely invested in equities in 2018 with the allocation as follows:
- Large Cap – 50 %
- Mid Cap – 25%
- Small Cap – 25%
would have experienced a loss of 6.3% in their portfolio, potentially encountering significant challenges in meeting financial obligations.
- On the other hand, a well-diversified portfolio with asset allocation of:
- Equities – 70% (50% large cap, 10% mid and small cap each)
- Gold – 15%
- G Secs – 15%
would have positive returns of 1.72% in 2018. This is the benefit of asset allocation; a well-diversified portfolio reduces drawdowns during bear markets and enhances portfolio stability. This would enhance your ability to meet financial obligations in such periods, if any.
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To conclude, we know that the investment journey comes with many twists and turns. Markets inherently are volatile; they rise and fall over time. So, an investor should build a well-diversified portfolio wherein investments are allocated to the different asset classes to ride this wave of volatility. By prioritizing asset allocation in your investing approach, you’ll steadily progress towards achieving your goals with each passing day.
