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Whether you’re new to investing or a seasoned professional, you may already be familiar with some of the most fundamental concepts of sound investing. How? With the help of lived and ordinary experiences. Some of the best investment advice comes not from a deep knowledge of the complex workings of markets, but from a deep understanding of everyday human experiences. Asset allocation is no different. It stems from the basic human tendency to mitigate risk and prepare for uncertain outcomes.
What is Asset Allocation?
Biology 101 tells us that a balanced meal is important for a healthy metabolism. Your diet cannot contain only protein. You need to balance carbohydrates, proteins, minerals, etc., to maintain a healthy lifestyle.
Similarly, asset allocation is the process of dividing an investment portfolio into different asset classes such as stocks, bonds, stocks, gold, etc. The argument is that asset allocation helps investors minimize risk in their portfolios because each asset class has a different risk factor. , growth and profits correlate with each other.
The optimal asset allocation for you at any given stage in your life is largely determined by your time horizon and risk tolerance.
Importance of asset allocation
Here are three main reasons why asset allocation is vital for your portfolio:
Portfolio stability: Different asset classes offer different investment cycles that hardly affect each other in terms of return. This allows you to invest in assets so that even if one class takes a hit, your overall portfolio does not. A diversified portfolio across all asset classes minimizes risk and adds stability over your time horizon.
Risk vs Reward: Risk is a double-edged sword. Or as they say in gym circles: no pain, no gain. Risk is an inherent property of each investment class, which is directly proportional to potential returns. Asset allocation allows you to toe the line and find a balance so market fluctuations don’t jeopardize your portfolio.
Diversification: Diversification is the process of allocating your investments between multiple asset classes to minimize risk. It’s the classic “don’t put all your eggs in one basket” warning. Factors that cause one asset class to underperform may allow another asset class to thrive. People invest in a variety of asset classes in the hope that if one loses money, the others will compensate.
Here are three of the most popular asset allocation strategies:
Strategic Asset Allocation: This is based on target allocations for each asset class, where you maintain the allocation range regardless of market conditions. For example, suppose the required allocation is 70% equity and 30% debt. If the stock market goes up 25% and debt yields 6%, the asset allocation will be 73% equity and 27% debt. Strategic allocation then calls for selling stocks and buying bonds to bring the asset allocation to 70% stocks and 30% debt.
Dynamic asset allocation: This strategy encourages you to adapt your allocation according to market conditions. For example, as stock valuations rise, you can reduce your stock allocations and increase debt allocations. And vice versa when stock valuations fall.
Tactical Asset Allocation: Tactical allocation is the opportunistic middle ground between strategic and dynamic asset allocation techniques. Investors can deviate from their basic strategies to take advantage of market opportunities. Tactical asset allocation requires in-depth knowledge of investments and a sense of market timing.
Rebalancing is the process of returning your portfolio to its original asset allocation balance. Over time, some of your investments may drift away from your goals, and some may grow faster than others. Rebalancing your portfolio ensures that one or more asset groups are not overvalued and brings your portfolio back to a comfortable level of risk.
Here are some ways to begin the process of rebalancing your portfolio:
1. Sell overweight asset class investments and buy underweight asset class investments.
2. Buy new investments in underweight asset classes.
3. Adjust your portfolio contributions so that more money goes to underweight asset classes until your portfolio is balanced again.
Get started with asset allocation
Here are some basic steps to start your allocation journey:
● Consult your financial advisor
● List your financial goals
● Assess your time horizon and risk factors
● Invest in an appropriate mix of asset classes
● Review your portfolio annually
It is almost impossible for anyone to predict the direction in which an asset class will move at any given time. Thus, it can help you view your investment portfolio as a team of individuals (asset classes) that each contribute to a single financial goal, instead of separate asset classes with inconsistent strategies.
As legendary American football coach Knute Rockne once said, “I don’t play my best XI, I play my best XI.”
Disclaimer: An Investor Education and Awareness Initiative by Mirae Asset Mutual Fund
All mutual fund investors must go through a unique KYC (Know Your Customer) process. Investors should only deal with registered mutual funds (RMF). For more information on KYC, RMF and the complaint procedure in the event of a claim, you can consult the Knowledge Center section available on the website of Mirae Asset Mutual Fund.
Investments in mutual funds are subject to market risk, read all plan documents carefully.