The basic premise of asset allocation is that different assets give different returns in different economic scenarios. Instead of putting all your eggs in one basket, you should diversify your investments so that you can take advantage of different market conditions. The portfolio will have assets whose returns are not perfectly correlated and this reduces portfolio risk. It also has the potential to give higher returns over a longer period of time.
It is important to get the right mix of assets in your portfolio and it is even more important to review this mix in different conditions and different stages of life
Typically the advice given is that you should subtract your age from 100 and number is the percentage of the portfolio that you should keep in equity and the rest you should invest in other assets. For example, if you're 25, you should keep 75% of your portfolio in stocks. If you're 75, you should keep 25% of your portfolio in stocks. But this is a very simplistic view and other factors apart from age should be considered. There are different stages in life based on various events.
For example if you are have children who will be going to college soon or are planning to buy a house in the near future, the asset allocation should be such that there is capital preservation and assets can be cashed out soon.
If you are a young person who has just kick started his/her career and do not have any financial obligations, you should have a more growth oriented asset allocation. You can invest in assets that have a greater reward potential. Typically since your income will be growing each year and savings will increase each year, you can invest more and build a large portfolio. Typically you can have a majority of your investments in equity and equity based Mutual Funds.
Asset allocation also depends on risk tolerance and risk capacity. Risk capacity is the measure of risk that can be afforded by you based on your financial situation. Risk tolerance is the measurement of how great a loss/risk are you willing to bear as an investor without being emotionally or financially affected regardless of the capacity of risk your financial health permits. It is very important to consider these factors along with other factors like goals, market conditions etc.
BEST PRACTICES FOR ASSET ALLOCATION
- Start asset allocation as early as possible – One should invest from a young age and also build a diversified portfolio from that time. When you are young, you can invest a higher percentage in stocks which have a higher reward potential though are more risky. But at that time generally risk capacity is higher.
- Elicit your long term financial goals – List down your financial goals with a clear timeline as to when the goal is to be achieved.
- If you are not sure of planning your finances independently, get a qualified financial planner. You can read more about getting the right planners here.
- Regular re-balancing of your portfolio is an essential element of long-term investment success.