Key elements of asset allocation and why we should get it right

When we decide to get serious about our finances and consult a financial advisor, we often hear the terms asset allocation, financial planning, diversification across asset classes, etc. A lot can be read and heard about emphasis on asset allocation. Let us delve into what it means and why it forms the bedrock of any serious financial plan.

Asset Allocation Explained

Simply put, your ideal asset allocation is the mix of investments; from most aggressive to safest, that will earn the total return over time that you need. The mix includes stocks (equities), debt instruments, cash or money market securities, gold, real estate, etc. Asset allocation cannot be generalised. It is subjective and differs for every individual. Your overall asset allocation is based on your age, risk appetite and financial objectives.

Age

Age plays an important role in deciding the percentage allocation to a high-risk high return asset class like Equities or a moderate to low risk one like debt instruments. There was an age-old thumb rule for investing in equities; which was 100 minus your current age with respect to asset allocation in equity and the rest in debt. E.g. if you are 35 years old then 65% of your investments need to be in equities (100 – 35) and 35% in Debt. However, not all individuals are the same despite of being in same age group; hence the thumb rule of 100 – (minus) your age = equity investments does not apply for everyone. Yes, one thing where age does matter is how much time you can give your money to grow. Usually when you are young, you can give more time to your money whereas at higher age you may need most of the money in the short term.

Risk Appetite

Traditionally, younger investors can invest more in equities as they can afford to take the additional risk and they can build their corpus over a period of time. As we grow older, the risk-taking capacity reduces and substantial amount of investments start tilting towards debt securities to keep our capital safe as you will not prefer to see high fluctuations in your overall portfolio in case something goes wrong.

Risk appetite can also differ based on other factors like number of dependents on your income and your past experience with different investment options. If the younger individual say has more dependent family members and she / he is the only earning member then her/his appetite for risk will be considerably lower as any major impact on overall finance can derail not just her / his plans but also affect other family members.

Also, your past experience with different investment options will define your comfort and ability to invest again in the same asset class. Better the experience and comfort in terms of risk and reward, higher is the risk-taking ability in that particular asset class.

Financial Objective

We all have more than one financial objective at any point of time. All these goals can be classified as either short, medium or long term in nature. If your financial objectives are near term in nature, the asset allocation for those goals will be high in safer assets. For your long term goals, you can investment more in asset class where the potential to earn higher return in long term exists with some additional risk. Each of your financial goals will have its own asset allocation and hence your overall asset allocation is the sum of asset allocation across all financial objectives.

It is very likely that asset allocation of you and your friend in the same age group along with same risk-taking ability may differ and may continue to be different, as both of you have different financial objectives.

Conclusion

So, based on your age, risk appetite and most importantly your financial objectives you should begin to optimize your asset allocation – i.e. how much should you invest in equity, debt and other asset classes. It may be a good time to just re-assess your asset allocation. If things are in place, then you are on the right path and the key is to maintain it. If not, then initiate necessary changes right now rather than compromising on your financial objectives in future. Because right asset allocation plays a significant role in your overall financial plan.

(The writer is co-founder, MyWealthGrowth.com. Views expressed are personal)