Significance of Asset Allocation

When it comes to matters related to investments, asset allocation is one aspect which you cannot overlook. Asset allocation is the practice of investing one’s money across various asset classes such as equity, debt, real estate and commodities, etc. on the basis of one’s goals, risk appetite and investment horizon. This approach fundamentally aids in minimising risk and optimising investment returns. It works on the often said premise of ‘don’t put all your eggs in the same basket’. Given below are the five reasons which make asset allocation a non-negotiable aspect on one’s investment journey.

Diversification Minimises Risk — Adhering to asset allocation ensures that your portfolio is diversified across multiple asset classes. Each asset class is influenced by different factors. So, even in case of an extreme development in one asset class, the portfolio is not adversely impacted, thereby helping minimise the risk to the portfolio. For example, during the initial phase of the pandemic, Indian equities had faced a sharp correction. At the same time, debt was relatively unaffected while gold rallied as investors globally opted for safe haven asset classes. If a portfolio predominantly consisted of equities, it would have been badly affected but if it was diversified across asset classes then the downside risk would have been relatively lower.

Increased Focus on Financial Goals — When deciding on asset allocation, there is an increased focus on financial goals and their investment horizon. For instance, one may have a short-term goal of buying a car with an investment horizon of two years. On the other hand, planning for retirement that is 20 years away is a long-term goal. Both these goals require different investment approaches and varying levels of investments in different asset classes. This approach ensures that financial goals are achieved in a planned and hassle-free manner.

Reduces the Impact of Investment Biases — Even if we call ourselves rational beings, it is common for investors to have investment biases. Often they are trapped in cognitive biases such as recency, confirmation and loss aversion, leading to wrong investment decisions. In this respect, asset allocation, to a large extent, minimises these cognitive biases by ensuring that investment exposure to various asset classes is made in a planned manner. This ensures that one cannot tinker with allocation on the basis of the changing moods, thereby insulating the portfolio from biases.

Review and Rebalance Factor — Putting together a portfolio and waiting for it to deliver is not the end one’s financial planning. One must review and rebalance the portfolio as and when required to maintain optimal asset allocation. Since life is all about change, it becomes imperative for the investment portfolio as well to keep up with the changes on one’s life goals and requirements. For instance, if you are comfortable with investing 50 per cent in equities and 50 per cent in debt, post a market rally this allocation could have been distorted to 80 per cent in equities and 20 per cent in debt.

This calls for trimming some of the equity holdings or increasing the debt allocation to bring the portfolio back to the original allocation ratio. Also, as one ages the risk profile tends to change and so does asset allocation. For example, a 30-yearold may be very comfortable with an overweight stance on equities. But as the individual ages, by the time he is 45 years his risk appetite would have changed and the same needs to be mirrored in his asset allocation or portfolio as well. In effect, asset allocation ensures that you are geared in a way to fulfil your financial goals by taking risks that are aligned with you. 

Tax Consideration — When investing without an asset allocation mindset, it is very likely that you may succumb to short-term market movements. This constant churning has the potential to increase your tax outgo in terms of capital gains. However, investing as per your ideal asset allocation makes you less likely to take short-term calls on the basis of current news and events. Hence, the capital gains on your investments will be limited to rebalancing exercises. To conclude, asset allocation has an important role to play when it comes to achieving one’s financial goals. If you are unsure how to go about it, seek the help of a financial advisor or opt for asset allocation-based mutual fund offerings.

The writer is Partner, Cliff Associates ∎ Email : rahul@cliffassociates.com ∎ Website : www.cliffassociates.com