Factors to consider for optimal asset allocation

Most people are confused when it comes to deciding where to invest their savings. Some of them put their money into equities in expectation of higher returns without giving a thought to the risks involved, while the risk-averse people simply opt to invest in fixed deposits of banks to derive stable and (almost) risk-free returns and some others may prefer to buy gold and keep it for posterity as a family heirloom. Since these people do not have a proper asset allocation plan in place, they tend to invest in a haphazard manner. As a result, they may be taking undue risks investing a large chunk of their savings in equities, or they may be compromising on the returns by investing a major portion of their savings in fixed income securities such as FDs, or they may be missing out on short-term returns by investing in gold or real estate. More importantly, they may not be able to achieve their financial goals if they keep investing haphazardly.

The factors that need to be taken into account for optimal asset allocation include return expectations, risk appetite, income level, age and financial goals.

Expectation of returns: The expectation of returns plays a crucial role in determining the choice of asset for investment, so the higher the expectation of returns, the riskier will be the choice of investments, which will include equities and equity-oriented mutual funds.

Risk appetite: The risk appetite of a person also dictates the choice of investment as a person with higher risk appetite will choose a risky asset such as equity for investment, while a risk-averse person will opt for comparatively safer investment avenues such as fixed deposits, bonds, debentures, etc.

Income level: The higher the income, the higher the risk appetite and more the choice of assets to invest in, and vice versa. So, a person earning over a lakh of rupees per month will have higher risk appetite than a person earning Rs 25,000 per month and choose to invest more in riskier assets. Also, he will have more choice to invest in various asset classes.

Age: The age factor is crucial as higher the age, lesser the risk appetite. A person of 50 years of age will prefer to invest in fixed income securities, while a young guy in his 30s may invest more in equities. The latter can afford to lose money since his earning life is more, while the former has barely a decade left to earn.

Financial goals: The financial goals of a person can determine the choice of assets he invests in. If the financial goals are long term, he may invest in assets that will provide stable returns over the long term such as gold, real estate, term deposits, etc. while if the financial goals are short-term, he can opt for short-term investment such as bonds, debentures, etc.