Beginner's Guide To Asset Allocation

Don’t put all your eggs in one basket, goes an adage we have heard since school. The story however, dates back to 1605 when Spanish author Miguel de Cervantes wrote in his book Don Quixote "It is the part of a wise man to keep himself today for tomorrow and not venture all his eggs in one basket." Well simply put it means if you put all your valuables (eggs) in a single place (the basket) you risk losing everything, all at once, if something were to happen to that basket.

And over time this learning has been aptly used in the world of business, investing, risk management and financial planning. And therefore modern-day financial advisors can’t stop emphasising the importance of Asset allocation when it comes to growing your wealth and investing your hard-earned money.

 Beginner's Guide To Asset Allocation

Asset allocation refers to the process of choosing different asset classes for investment purposes. An asset class is a collection of securities having similar characteristics, attributes, and risk/return relationships. Examples of asset classes are equities, bonds, cash & cash equivalents. Asset allocation for an individual/family aims to optimise the portfolio based on one’s risk appetite, corpus available, time horizon and financial and life goals.

This is helpful because every type of asset class has its own cycle in terms of ebbs and flows, and depending on which asset class is at which stage in its own cycle, one’s exposure to that asset class can vary. Therefore, you essentially safeguard yourself from the impact of market volatility on your overall portfolio and enhance its stability over time.

It also offers flexibility and adaptability given the changing markets and individual goals. Diversification through asset allocation aligns with the idea of long-term stability.

And today we have multiple options to choose from. It is important to make a financial plan to understand which investment tool can be matched with which goal. Before we look at the various asset classes let's look at the determining factors and how a strategy is very important.

A good asset allocation strategy will help you achieve both short-term & long-term goals by tailoring your asset allocation based on where you are in the journey as well as the market conditions at any given point in time. Important in this narrative are your time horizon, risk tolerance and life circumstances. If you are looking at having liquidity you can’t park your money in tools that lock the access to it and when withdrawn ask you to pay damages. 

Similarly, if you are planning for a retirement fund a part of the portfolio can be invested in long horizon investment tools. What is essential is to list your financial goals which must include the creation of an emergency fund, health coverage and retirement fund amongst others.

Now let's look at the different asset classes. Primarily the asset classes are divided into equities, fixed income, cash and cash equivalents each behaving differently over time. 

They can be classified as follows-

• Equities (Stocks): Ownership shares in a company.
• Fixed Income (Bonds): Debt securities that pay periodic interest.
• Cash & Cash Equivalents: Short-term, highly liquid assets like money market instruments.
• Real Estate: Physical property or land.
• Precious metals such as gold, silver, platinum

When we talk about equities it is important to understand that they are a key component for long-term growth. Fixed-income bonds are debt securities issued by governments, corporates or other financial entities and they provide regular interest payments and are generally considered less risky than stocks. Bonds can add stability to a portfolio. Fixed income is directly impacted by the interest rate set by the Central Bank, which can change based on macroeconomic factors - again, the allocation in one’s portfolio for fixed income can vary based on the needs of the investor.

Cash Equivalents include short-term, highly liquid investments like money market funds. Keeping cash at hand is also a strategic decision, as having liquidity allows you to take advantage of sudden opportunities that might arise, like a stock market crash.

Then of course comes physical assets like real estate and commodities, such as gold. Under both categories other than the tangibles there also is the presence of REITs (Real Estate Investment Trusts) and Sovereign Gold Bonds (SGBs) which are bonds issued by the government where the underlying asset is gold.

Similar to REITs are InvITs. Infrastructure Investment Trusts (InvITs) are financial instruments that enable investors to participate in income-generating infrastructure projects, such as roads and power plants. They function as trusts, distributing returns generated from these assets to unit holders. 

Well, options are several which is why in this journey you will need help. A financial advisor can monitor and rebalance your portfolio from time to time and keep an eye on the best possible options for asset allocation and diversification in your portfolio. 

Author, investor and philanthropist Davide Swensen rightly said, "Asset allocation is the primary determinant of your portfolio returns. It’s not about which stocks or mutual funds you pick; it’s about your overall exposure to stocks, bonds, and other asset classes." 

The article is published in collaboration with the BSE Investors’ Protection Fund to spread awareness with respect to personal finance and investing, especially for women.