The ultimate guide to understanding asset allocation

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Asset allocation is probably the most strategic decision an investor makes. It’s the strategy of deciding how to spread your investments across different asset classes, such as equity, debt, cash, gold, real estate, etc. The goal is to create a portfolio that meets your investment objectives and hedges risk.

While there is no “perfect” asset allocation for all investors, there are some general guidelines and strategies that can help you create the right investment portfolio. Here is a detailed overview of asset allocation, its importance, and how different asset classes can be used in your portfolio.

How does asset allocation work?

understanding asset allocation

Asset allocation works by dividing your investment portfolio among multiple asset classes. For example, if you have a portfolio of Rs 10,00,000, you might allocate Rs 6,00,000 to stocks and Rs4,00,000 to bonds to get diversification among different asset classes and reduce risk.

There are different ways to allocate your assets, but a common approach is using the 60-40 rule. This rule of thumb says that you should invest 60% of your money in equity instruments and 40% in debt instruments.

Types of assets to invest in for portfolio rebalancing

There are several different asset classes that you can choose from. Some of them include:

  • Equity-oriented investments, such as stocks and equity mutual funds, can offer the potential for high returns, but they also come with a higher degree of risk.
  • Debt-oriented investments, such as debt mutual funds, bonds, and fixed deposits, tend to be less volatile, but they also typically offer lower returns.
  • Gold investments, such as gold exchange-traded funds, can provide a hedge against inflation.
  • Real estate, such as commercial or residential property and units of Real Estate Investment Trusts (REITs), can be a wise investment if you buy carefully.

Why is asset allocation crucial for investors?

Diversification reduces risk

Asset allocation is a smart investment strategy through which you can pool your money across different types of investments to diversify your portfolio and reduce risk. The idea is that by investing in various assets, you will be less likely to lose money if one investment performs poorly.

Eliminates timing the markets

Timing the markets is difficult and can result in missed opportunities if market conditions change unexpectedly. Investing inproducts like mutual funds with proper asset allocation not only reduces the risk of investing in a single asset class but induces a more systematic approach to investing, thus eliminating the approach of timing the market.

Addresses liquidity needs

Many investment products have a lock-in period, meaning you cannot access your funds during emergencies. However, proper allocation ensures that your investments are properly aligned with your liquidity needs.

Ending note

Asset allocation is an important technique that can help you reach your financial goals strategically. You can develop an asset allocation plan by using an asset allocation calculator available online. Simply enter your age, risk tolerance, and time horizon. Based on your answers, the calculator will recommend a specific mix of assets that align with your financial objectives. Also, remember that you may need to undertake portfolio rebalancing periodically to ensure that your investments remain aligned with your financial goals and risk tolerance over time.

 

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