Asset Allocation Meaning: Asset Allocation Strategies that Work in 2022
Asset allocation has become a gold standard in investing globally. Most sophisticated investors starting from family offices, ultra-HNI to a significant retail customer base in mature markets in the US, and Europe, have adopted asset allocation as their primary investment strategy. In this article, you will learn about how important is asset allocation.
But first - what are asset classes?
Asset classes are investment groupings that show similar market characteristics in terms of risk and return.
Asset allocation, therefore, refers to a strategy that seeks the right balance between risk and reward for an investor, by adjusting investments in different asset classes based on risk appetite, goals and comfort.
From an investment point of view, asset allocation is a tried and tested method in protecting your portfolio from market fluctuations—an approach every investor should prioritize.
To understand the criticality of asset allocation, let's look at some major asset classes, which you're likely to be familiar with anyway:
In conventional terms, equity is a representation of a stake in a company. Represented by shares, equity assets trade on stock exchanges like National Stock Exchange (NSE) and New York Stock Exchange (NYSE).
Equity assets are arguably the most critical asset class, owing to their high potential for returns and their ability to beat inflation comfortably.
Equity is a combination of domestic equities and international equities. Domestic and foreign companies operate in entirely different market conditions. Hence their stocks exhibit distinct behaviours, an essential reason for diversification.
Investing in debt is the same as fixed income investing, and involves investing in debt securities like bonds that produce a return rate in the form of interest.
Debt is a less risky asset class compared to volatile equity investments. Debt investing provides a predictable rate of returns - making it one of the most popular asset classes.
Cash or cash equivalents like short term debt instruments have high credit quality and are highly liquid. Simply put, they represent the cash in hand of a company or an investor.
#4 Real estate
Real estate can be residential, office, industrial, retail, and hospitality - each with its own set of risks and rewards. Real estate assets have the highest cost of entry and are the most illiquid.
#5 Currencies & Commodities
Investing in different currencies involves generating returns based on fluctuations in currency value. They are typically a preference amongst experienced investors.
Commodities are also famous for investors wishing to speculate on future commodity prices. Popular commodity investments are gold, silver, and oil.
Under an asset allocation strategy, assets are proportionally invested in different asset classes based on an investor's risk tolerance, goals, and investment horizon. It is the process of diversifying your investor based on individual demands and requirements.
Most financial advisors and pundits strongly advocate asset allocation. It not only diversifies risk but also amplifies gains. Let's check out why asset allocation matters.
- 90%+ investment outcome is determined by asset allocation, not trying to the right fund:
Multiple studies have consistently demonstrated that 90% of returns come from asset allocation, with only 10% from the type of fund you buy. Most of Dalal Street and Wall Street is getting you to buy a fund. The reality is the fund you buy has little significance. What matters is how you split your money across different asset classes.
- Risk diversification:
Asset allocation significantly diversifies your risk exposure. A diverse portfolio is a blend of different market reactions at the time of a financial event.
For example, during the 2008 market crash, the equity sector was catastrophically affected. On the other hand, gold, a popular commodity asset performed fiscally better, delivering profits to the commodity holders. Being spread across these two assets would've considerably reduced volatility in the portfolio.
In 2020, international markets have fared better than Indian markets. An allocation to both would have helped investors reduce volatility and get downside protection.
- Lower portfolio volatility:
While each asset class has its share of risks and rewards, diversifying your investments also dilutes volatility.
For example, investing in equity assets and debt assets will protect your portfolio from experiencing the impact of a dip in any unique asset. Within equity markets themselves, you can invest in domestic and international equity markets
Both markets will deliver different results. Since each is prone to a distinct set of challenges and market trends, their performance varies.
- Lower stress:
Spreading assets across multiple asset classes reduce the volatility, as we just noted above. It significantly reduces your stress regarding the safety of your investments. Lower stress helps investors cope up with volatility in a much better way. It also fosters discipline and helps investors invest in regular intervals.
- Asset allocation maintains discipline:
When you spread your investments across assets, as a rule, you're teaching strong discipline and avoiding instant gratification. Asset allocation ensures the investor is not over-invested or under-investor in a particular sector.
It also ensures that an investor is not being greedy and taking excessive risk, or even being fearful and taking too little risk.
- Stable returns:
Asset allocation ensures that you get stable returns over time. For example, say Anuj wants to invest his savings of Rs. 4,00,000 for a time horizon of 4 years. Based on his financial consultant's advice, Anuj can divide his investments among different classes. A mix of 25% each for Equity, Debt, Gold, and Liquid Fund, which he rebalances each year.
Such a well-balanced portfolio would've delivered negative returns (of 1.3%) only once - during the 2008 financial crisis. On the other hand, it has delivered a CAGR of 11.11% over the years.
This ensures that the risk is proportionally diversified, and over 4 years, Anuj gets stable returns on his investments.
This goes beyond saying that asset allocation or portfolio diversification is a tricky and stressful task. Since we don’t know how a particular asset class might perform, there is always some level of associated uncertainty. But clearly defining your financial goals and risk tolerance makes the task considerably easy.
Importance of Asset Allocation
Various asset types are developing in different directions. All asset classes rarely perform in perfect sync. One could believe that investing in mutual funds that are performing very well at a certain period is the greatest way to time the market.
It is, however, incredibly difficult to forecast the direction in which any asset class will move at any particular point in time. For example, when equities rise, the gold investment may plummet, and vice versa. As a result, diversifying your portfolio across asset types makes sense. This is done so that if one group of asset classes or funds underperforms, the underperformance of the other asset classes will balance it out. Investing all of one's money in a single asset class or mutual fund strategy can be extremely risky. When an investor's money is distributed among asset classes, on the other hand, it produces superior returns.
Factors that Affect Asset Allocation
The process of deciding on the proper asset mix for your portfolio is extremely personal. An investor's asset allocation decision is influenced by several aspects such as personal financial goals and objectives, risk appetite, and investment horizon while making investment selections. Let's have a look at these variables.
- Time Horizon: The amount of months or years an investor expects to invest to reach a specific goal is referred to as the time horizon. Different risk tolerances are associated with different investment horizons. A long-term investing horizon, for example, can lead an investor to invest in a higher-risk portfolio, as slow economic cycles and high market volatility tend to fade over time.
- Risk Appetite: An investor's risk tolerance refers to their willingness and ability to lose some or all of their initial investment in exchange for higher prospective returns. Aggressive investors, or those with a high-risk profile, are more likely to risk the majority of their assets in order to increase their profits. Conservative or risk-averse investors, on the other hand, are more prone to invest in securities that protect their original assets.
- Risk Vs Returns: Risk and rewards are inextricably linked when it comes to investing. The saying "no pain, no gain" perfectly encapsulates the risk-reward connection. Risk is inherent in all investments. When you take a risk, you get rewarded with a larger chance of making a profit.
How does Asset Allocation work?
Asset allocation is based on the characteristics of several asset classes. When the economy advances in a certain way, each asset class may perform differently. Some assets rise in value as the economy grows, while others may remain flat or even fall in value, depending on the conditions.
This non-correlated quality allows investors to construct portfolios that zig when the market zags. An investor or financial adviser can make a portfolio less volatile by mixing and matching the attributes of asset classes, potentially achieving the same or greater returns as a riskier portfolio. To mitigate risk, asset allocation makes use of the notion of diversity.
If you have 30 years till retirement, for example, you can afford to assume more risk in exchange for bigger potential gains in the stock market. As a result, a financial adviser or robo-adviser would typically propose a larger stock allocation and a lower bond allocation.
Strategy for Asset Allocation
There are no hard and fast rules for how an investor should invest in asset allocation, and different financial advisors take different approaches. Some of the most popular mutual fund asset allocation strategies used to influence investment decisions are as follows:
Asset allocation for life cycle funds
This technique, also known as target date asset allocation, aims to maximise an investor's return on investment (ROI) based on characteristics such as the investor's age, investing goals, and risk profile. Critics, on the other hand, argue that this type of portfolio structure is complicated due to standardisation concerns.
Asset allocation determined on age
The investor's age is taken into account in this asset allocation approach. To calculate the percentage of assets that should be invested in equity mutual funds, financial gurus suggest deducting an investor's age from 100. Other asset types, such as debt, should be used to invest the remaining funds. If you're 30 years old, for example, you should put 70% of your money into equity funds and 30% into other asset classes.
Constant Weighted Asset Allocation
This buy-and-hold approach, also known as strategic asset allocation strategy, is based on the buy-and-hold policy. If one asset type, such as stocks, loses value, investors are advised to buy more of that asset class, and vice versa. The goal is to ensure that the asset class proportions do not depart more than 5% from the initial composition.
Tactical Asset Allocation
This plan addresses the issues that may occur in the long run as a result of a strategic asset allocation strategy. As a result, the goal of this strategy is to maximise short-term investing techniques. This flexibility adds a market-timing component to the investment portfolio, allowing an investor to participate when economic conditions favour one asset class over another.
Insured Asset Allocation
This technique establishes a base asset value below which the portfolio should not be dropped. If the portfolio's value falls, the investor should take steps to mitigate the risk, such as investing in risk-free assets such as Treasury Bills (T-bills). This investment technique is appropriate for risk-averse investors. An investor seeking a minimum standard of living after retirement, for example, may find this method to be excellent for their financial objectives.
Dynamic Asset Allocation
This is one of the most often used investment methods. An investor uses this technique to constantly modify the asset mix based on market highs and lows, as well as gains and losses in the economy. This technique entails buying assets that show signs of continuous market gains and selling assets that show signs of continued market losses.
Should you focus only on equities?
Equities seem to be the best and most lucrative option over the long term compared to other asset classes. And historical data backs this claim.
Take a look at the figure above - the Sensex has considerably outperformed other asset classes over the years. Equities, therefore, are deserving of an investor's attention and time.
However - by investing your money solely in equities, you may be increasing your risk exposure. Equity assets are also considered the riskiest of all asset classes, despite their attractive return generation abilities.
Even though equity investments always go up over the long periods, most investors do not have the capability to handle the wild swings of equity markets. A few instances below:
- The 2007-08 financial crisis remains a famous instance of why you should not put all your investments in a single asset class.
- The coronavirus outbreak is the most recent example of how fear and uncertainty can result in equity crashes.
Some investors believe that the inherent risks of investing in equity assets can be tackled by investing 'smartly' and at the right time. Their perception is that buying the dips and selling the highs can shield investors from catastrophic events. But reality doesn't work this way.
The Truth About Timing The Markets
While some individuals might voice their support for market-timing, it is not a practical strategy. Chasing returns by buying the highest performing stock or mutual fund is also a form of market timing.
Peter Lynch once said, "Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections than has been lost in corrections themselves."
Market timing is an investment strategy that involves an investor predicting future market prices before making their investment. But market timing has repeatedly shown that it fails as a money maker.
- A comprehensive study of stock market newsletters by MarketWatch shows that most stock-picking strategies fail
- A Forbes article found market-timing by professional money managers to be flawed. Individual investors are clouded by their emotions while trying to time their equity investments.
The Bottom Line
Depending on the situation, asset allocation might be active or passive. The goals, age, market expectations, and risk tolerance of an investor all influence whether he or she picks a certain asset allocation plan or a combination of techniques.
However, keep in mind that these are merely broad suggestions for how investors can include asset allocation into their fundamental strategy. Be mindful that techniques to allocation that entail reacting to market changes necessitate a high level of experience and aptitude in the use of certain tools to time these moves. It's nearly hard to time the market perfectly, so make sure your technique isn't too exposed to unanticipated blunders.
While there are instances of successful market timing, they are often mere luck.
So what is the ideal way of investing that guarantees substantial returns and minimizes risk?
As a rule of thumb, try to diversify within your diversification. A blend of asset classes is crucial for generating healthy returns. Think asset allocation!
Q1: What exactly is the goal of asset allocation?
A1: Asset allocation is an investment technique that tries to balance risk and reward by allocating assets in a portfolio based on a person's goals, risk tolerance, and investment horizon.
Q2: Why is Asset Allocation significant?
A2: Through diversity, asset allocation helps investors reduce risk. Stocks, bonds, and cash returns have never moved in lockstep in the past. Asset allocation, in addition to diversification, is critical to achieving your financial objectives.
Q3: What tactics do you use to diversify your asset allocation?
A3: Choose assets from a variety of businesses and markets to diversify your portfolio. When considering private equity or loan investments, look into industry trends for the private companies you're considering and choose companies in complementary industries.
Q4: When should you adjust your asset allocation?A4: The asset allocation can be modified as needed. Most people planning for retirement, for instance, keep fewer stocks and more bonds and cash equivalents as they approach retirement age. If your risk tolerance, financial status, or the financial goal itself changes, you may need to adjust your asset allocation.