by Mr. P. Saravanan, IIM Shillong
Asset allocation is the process of distributing an investor’s wealth
among different asset classes.
In other words, it is investing money in assets like equity, bonds,
real estate, precious metals & other commodities to ensure that your
investments are well-diversified.
Advantages..
Reduces investment risk..!
A diversified portfolio is
exposed to less risk as growth prospects are not limited to one security, but
rather a basket of risky and non-risky securities across equity, debt, gold
& real estate.
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| P. Saravanan, IIM Shillong |
Less dependence on one asset class..!
Not all assets in a single asset class perform well at the same time.
That’s why it’s important to choose different stocks and different categories
of mutual funds.
In fact, funds need to be allocated efficiently even within the
category.
Hedge against volatility..!
Anybody who invested before or / during the sub-prime crisis knows
that when equities took a beating, debt & gold kept investors afloat. Those
with pure equity portfolios are unlikely to repeat the mistake.
A well-allocated portfolio will protect you, and even offer growth,
during times of volatility.
Freedom from market timing..!
Those who try to time the
market can testify to its volatility. Imagine timing market movement across
different asset classes.
Investing minus stress is not very hard if you stop timing the market
and implement a disciplined strategy.
Asset allocation & diversification are not the same.
Diversification can be explained by the adage, ‘do not put all your eggs in one
basket’. it involves spreading your money across instruments in the hope that
if one investment loses money, others will more than make up for the loss.
Many investors use asset allocation as a way to diversify investments
across asset categories.
For example, a 25-year-old investing for retirement can look at only
equity, and a family saving for the downpayment of a house can invest entirely
in cash equivalents.
Though reasonable under given circumstances, neither strategy
attempts to reduce risk by holding different types of categories. So, choosing
an asset allocation model would not necessarily diversify your portfolio.
Whether your portfolio is diversified or / not will depend on how you spread
the money among different types of investments.
Diversification..
This should normally be done at 2 levels. One, across asset
categories and, two, within a category. Apart from allocating investments
towards stocks, bonds, real estate, precious metals, other commodities, private
equity & other asset categories, you will also need to spread investments
within each category. The key is to identify investments in each category that
may perform differently under different market scenarios.
One way of diversifying your investments within an asset category is
to identify and invest in a wide range of companies and sectors. But the stock
portion of your investment portfolio would be diversified if you invest, for
example, in just 4 to5 stocks. You will need at least a dozen carefully
selected stocks to be truly diversified.
Each individual’s financial plans and investment needs are different,
changing with the life stage. How an individual structures his asset allocation
strategy should depend on his age, financial status, future plans, risk
aversion and needs. Asset allocation is not an isolated choice, but a component
of the portfolio management process.
The writer P. Saravanan is an associate professor in finance and
accounting at IIM Shillong.
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