How Asset Allocation Impacts Your Portfolio
Asset allocation is a very important part of creating and rebalancing your portfolio. It will ensure that your wealth grows rapidly and your portfolio’s risks are lowered to a greater degree.
Here is a guide, explaining what asset allocation is and how it can affect your portfolio.
What Is Asset Allocation?
Asset allocation involves dividing your investment among different assets, such as stocks, bonds, and cash. Anything outside these three categories (e.g., real estate, commodities, art) is often referred to as alternative assets.
Deciding on what kind of asset allocation works for you is a personal one. The allocation that will work best for you will depend on how long you have to invest and your ability to tolerate risk.
For example, someone who is in their 20s with a medium risk appetite will have 40% of the portfolio allocated to Large Cap Equity, 30% to Small Cap Equity, 20% to Cash and Equivalents, and 10% to Bonds.
However, a portfolio of someone in their 40s who have a low-risk appetite would look like this: 80% in Large Cap Equity and 20% in Bonds.
Why Do We Have To Do It?
Higher Returns – To get optimal returns, asset allocation is highly important. Some investors are either too aggressive or conservative and invest accordingly. Hence, they will not be able to earn adequate returns on their investments.
Proper asset allocation will help you understand how much return you can expect on your investments based on the risks you are taking.
Lowers Risk – Every asset class comes with its own share of risks and rewards. Hence, diversifying your investments reduces volatility.
When you allocate your assets, your portfolio risk is spread across asset classes. For example, investing in debt assets will protect your portfolio from market volatility.
Helps Maintain Discipline – Asset allocation ensures that you don’t over-invest or under-invest in a particular sector. It helps you maintain discipline and build financial security.
Reduce Taxes – If you are putting most of your money in fixed deposits, you would have to pay a lot of money as a tax upon maturity.
With asset allocation, you can reduce your taxes by investing in tax-saving fixed deposits, ELSS, etc., This will ensure you lower your taxable income and pay less tax in the process.
Decreases Stress – Spreading assets across multiple asset classes sharply decreases your stress regarding the safety of your investments.
Less stress promotes confidence and helps investors invest in regular intervals. Moreover, when you diversify your portfolio efficiently, you can cope with volatility or loss in a much better way.
Asset Allocation Strategies
There are six asset allocation strategies that can be used to boost your portfolio. They are as follows.
Strategic Asset Allocation
In this strategy, the fund has a static asset allocation mix. This mix in practical terms for mutual funds is usually a range, allowing the fund manager some freedom to manage the asset allocation within the specified range e.g. 65-75% equity and 25-35% debt.
The fund’s mandate establishes what the ideal asset allocation combination should be and the fund sticks to it, irrespective of market movements. However, from time to time, asset rebalancing is needed to maintain the mandated asset mix.
For example, let’s say, the mandated static asset allocation is 70% equity and 30% debt, and the stock market gains by 25% and debt gives a 6% return, then the asset allocation will be 73% equity and 27% debt.
The fund manager will sell stocks and buy bonds to bring the asset allocation to 70% equity and 30% debt.
A strategic asset allocation strategy might be similar to a buy-and-hold strategy and also heavily suggests diversification to lower risk and improve returns.
One of the main benefits of this strategy is that it enforces discipline in investments. A static asset allocation strategy is a long-term strategy, with a focus to reduce risk and help you meet your investment goals.
Dynamic Asset Allocation
In this strategy, you constantly adjust the mix of assets as markets rise and fall, and as the economy strengthens and weakens. Under this strategy, you will sell assets that decline and purchase assets that increase.
For example, if the stock market shows weakness, you will sell stocks in anticipation of further declines and if the market is strong, you will purchase stocks in expectation of continued market gains. This is also known as contra strategy.
Different fund managers use different valuation metrics for dynamic asset allocation, with the most common ones being P/E and P/B ratios.
Some fund managers use multi-factor asset allocation models, which combine 2 or more factors. Eg. P/E, P/B, Dividend Yield, etc., in dynamic asset allocation strategy.
Tactical Asset Allocation
Tactical asset allocation is a variant of strategic asset allocation strategy wherein the investor can occasionally deviate from the long-term strategic asset allocation to take advantage of market opportunities. This strategy calls for market timing and needs significant investment expertise.
For example, let’s say, your strategic asset allocation requires you to maintain a 70% equity and 30% debt mix. Sometime later, you think that equity can give higher returns in the short term.
You will tactically increase your equity allocation to 80% temporarily until you think that equity valuation is too high. The extra 10% allocation to equity will improve your returns in the short term.
You need to be disciplined while following this strategy, as you must first be able to identify when short-term opportunities have run their course and then rebalance the portfolio to the long-term asset position.
Constant-Weighting Asset Allocation
Strategic asset allocation generally implies a buy-and-hold strategy, even as the shift in values of assets causes a drift from the initially established policy mix.
In this approach, you continually rebalance your portfolio. For example, if one asset is decreasing in value, you would purchase more of that asset. But if that asset value is increasing, you would see it.
There are no fixed rules for timing portfolio rebalancing under strategic or constant-weighting asset allocation.
But a common rule of thumb is that the portfolio should be rebalanced to its original mix when any given asset class moves over 5% from its original value.
Insured Asset Allocation
In this strategy, you establish a base portfolio value under which the portfolio should not be allowed to decline. If the portfolio ever drops to the base value, you have to invest in risk-free assets, like Treasuries (especially T-bills) so the base value becomes fixed.
At this time, you would reallocate assets, perhaps even change your investment strategy completely.
This strategy might be suitable for risk-averse investors who expect a certain level of active portfolio management by appreciating the security of establishing a guaranteed flow below which the portfolio is not allowed to drop.
Integrated Asset Allocation
In this strategy, you consider both your economic expectations and your risk in establishing an asset mix. The other strategies mentioned above account for expectations of future market returns but not all of them accounts for the investor’s risk tolerance.
Meanwhile, this strategy includes aspects of all the previous ones, accounting expectations, as well as, actual changes in capital markets and your risk tolerance.
In The End…
Markets are volatile by nature, they can gain or decline at any time. The right asset allocation strategy will help you earn higher returns and minimize losses.
It will make sure that you get close each day to achieving your financial goals. Having learned all the different asset allocation strategies, are you ready to invest in a hyper-personalized investment solution?
Head over to Koshex and tell us your goals and risk tolerance. We will design a hyper-personalized investment solution that will suit your risk appetite and help you achieve your goals faster. Create an account with us today!