What is asset allocation?
Step 1: Know the different asset classes
|Asset Class||Return Potential||Risk Level|
|Equity||Moderately High to High||Moderate to High|
|Debt||Low to Moderate||Moderately Low to Moderate|
|Cash & Cash Equivalents||Low||Very Low|
|Real Estate||Moderate to High||Moderate to High|
|Commodities||Moderate to High||Moderately High to High|
|Currency||Low to Moderate||Very High|
No two investment portfolios or even asset allocation strategies are the same. The two main investment planning factors to keep in mind are:
- Time Horizon: A longer time frame minimises the impact of short-term volatility. If you are only looking at a horizon of a few years, a conservative portfolio with less risky assets would be ideal.
- Risk Tolerance: A high risk tolerance level could mean a portfolio that is heavier on high-return asset classes. But if you are conservative, you might prefer asset classes that are low-risk, lower-return.
Step 3: Identify your goals
Investment goal planning helps you identify the time horizon and risk tolerance level you are comfortable with. For instance, investment for retirement requires you to build a robust portfolio that can ride through market volatilities. When you are younger, your time horizon is longer and risk tolerance level is higher. However, as you near your retirement age, you need to rebalance your portfolio more towards lower-risk asset classes.
Step 4: Select your asset allocation strategy
You can choose from two broad asset allocation and investment planning strategies:
- Strategic Asset Allocation
With strategic asset allocation, you create a base policy mix or a fixed asset combination, depending on the expected returns in a year. For instance, let us assume that historically, equity has delivered 18% returns, bonds have delivered 8% and real estate has delivered 10% returns a year. In this scenario, a portfolio with 60% equities, 20% bonds, and 20% real estate could deliver up to 14.4% returns per annum.
- Tactical Asset Allocation
Tactical asset allocation refers to a strategy that shifts assets in a portfolio to take advantage of market trends or economic conditions. In other words, tactical asset allocation refers to actions in which asset classes such as stocks, bonds, cash, etc. are adjusted in the portfolio to account for macroeconomic and other events which may have an impact in the short term. Tactical Asset Allocation takes advantage of short term opportunities while staying on course in terms of long term objectives of the investment portfolio.
Ultimately, your asset allocation must protect you and create a portfolio that performs in every market condition. This can be a complex and consequential task, so consult a professional investment planning advisor in building your portfolio.
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