The recent Volatility in Market on account of COVID Pandemic has sensitized advisors and clients on the Importance of Asset Allocation in Investment Portfolio. Asset Allocation has been most talked about buzz word recently, but in my opinion most of the clients still do not understand the concept in true spirit. For most investors it is just allocation of Funds in various Asset Class viz., Debt Fund, Equity Fund, Stocks, Real Estate, Bullion etc…
Let’s try to understand the Importance of Asset Allocation in simple terms. Asset allocation is an investment portfolio technique that aims to balance risk by dividing assets among major categories such as cash, bonds, stocks, real estate, and derivatives. Each asset class has different levels of return and risk, so each will behave differently over time. The objective of Asset Allocation is to minimise volatility and maximise returns.
Asset allocation will be different for every investor. It is arrived at based on an investors age, lifestyle, goals and risk-taking appetite.
The Importance of Asset Allocation in Retirement Planning:
One has to understand the Importance of Asset Allocation in two Parts: First the need for Asset Allocation while creating Retirement Corpus and secondly Asset Allocation style in the Portfolio while reaching the Retirement Age.
Importance of Asset Allocation in Accumulation Stage:
It is important to decide Asset Allocation for creating a retirement corpus. After all, the overall returns that are generated are in direct proportion to what kind of an investment option one follow. Generally, the investment options may be equity-linked, debt-linked or a mixture of equity and debt-linked instruments.
Following are three important parameters that you must keep in mind while allocating your assets towards specific investment options:
Equity allocation: This is when you allot the bulk of funds towards high-risk and high-return equity instruments. As a rule, if planning late in life, high-risk allotments or investments must be avoided. However, if you are young and planning for retirement, then equity allocation can form an important part of your financial portfolio.
Debt allocation: Again, the allocation towards debt instruments that offer low-risk returns over a period of time must be done in a balanced manner. Depending on the kind of required coverage, debt funds must be duly covered under investment.
Hybrid or mixed allocation: This is considered to be the most viable and the balanced mode of investment, as this enables you to reap the optimum benefits without undue risks. Allocating your funds towards a mixed investment portfolio enables you to ensure a stable rate of growth for your money.
Smart Asset Allocation for Retirement Planning:
While it is impossible to come up with a universal formula for Retirement Planning, Asset Allocation must be done keeping the following factors in mind:
- Make high Risk Investments early in life
- Don’t focus on single asset class.
- Focus on Risk Mitigation even within the asset class. Balance direct Equity Investment with SIP investments to reduce the negative impact of loss of capital
- Review the Asset Allocation periodically to provide for changed circumstances.
- As Retirement Approaches focus on Assured Income, higher Liquidity and lower Risks by shifting from Equity to Debt Funds
- Last and not the least, have an inflation-targeted approach to ensure the Real Returns on your investment are adequate to provide for your retired life.
“The difference between success and failure is not which stock you buy or which piece of real estate you buy, it's asset allocation…”
Thus to sum up Investors should avoid making three most common Asset Allocation mistakes:
- Investing Too Conservatively: The longer your investment time horizon, the more equities you should have. Even recent retirees may have 30 years left to live, so be careful not to get too conservative too soon. Many people perceive risk as losing money in the near-term. A bigger risk could be not growing your money enough to fund a long retirement.
- Investing Too Aggressively: Two mishaps can occur by investing too aggressively. First, you may subject yourself to emotional errors such as selling your investments after a sharp market decline, and then, inadvertently missing out on the ensuing stock market rally. Second, if you are retired and taking money out of your portfolio to cover monthly living expenses, the portfolio may struggle to recover from a sharp stock market decline. This is not an issue when you are investing more funds with every paycheck (i.e. “buying low”) instead of taking money out when stock prices are down (i.e. “selling low”).
- Failing to Adjust Allocations: Rebalancing is the process of periodically bringing your portfolio back to the targeted asset allocation mix. Even if you initially established a proper asset allocation, market fluctuations and new contributions can move your portfolio away from your targets. We suggest rebalancing at least once per year or more frequently in the event of large market moves. Finally, you may want to change your asset allocation targets as life situations evolve (e.g. retirement, aging, inheritance, illness, etc.).
A trained investment professional can help determine an appropriate asset allocation after a thorough review of your situation and risk tolerance. Additionally, by diversifying within asset classes, the professional can seek to maximize your return given your asset allocation.
The Importance of Asset Allocation needs to be understood in 3 forms:
- Importance of Asset Allocation in Portfolio Construction: Asset allocation is important because it has a major impact on whether you will meet your financial goal. If you don’t include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal. For example, if you are saving for a long-term goal, such as retirement or college, most financial experts agree that you will likely need to include at least some stock or stock mutual funds in your portfolio. On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it. A portfolio heavily weighted in stock or stock mutual funds, for instance, would be inappropriate for a short-term goal, such as saving for a family’s summer vacation.
- Regular Monitoring & Re-balancing: Most of the times we forget that the change in Market dynamics or volatility also changes the Risk Appetite of investors. So the Asset Allocation strategy devised at the time of Constructing Portfolio may not hold true if market witness huge volatility. Thus with the change in market valuations, the allocation of investment in various asset class also need to be re-balanced. Asset Allocation Aims to generate Better Risk Adjusted Returns. For example, if the valuation of the Equities seems cheap, one should increase allocation to equities so when the Equity Market go up, Portfolio generates better returns.
The most common reason for changing your asset allocation is a change in your time horizon. In other words, as you get closer to your investment goal, you’ll likely need to change your asset allocation. For example, most people investing for retirement hold less stock and more bonds and cash equivalents as they get closer to retirement age. You may also need to change your asset allocation if there is a change in your risk tolerance, financial situation, or the financial goal itself.
- Minimising Risk in the Portfolio: Asset Allocation helps to reduce Risk in the Portfolio. Whenever the asset class becomes expensive for example, if the Equity Market has become expensive or over valued, one should change the Asset Allocation in the Portfolio by reducing exposure to Equities. There are many tools to understand Valuation of Equities for instance PE Ratio, Market Cap to GDP Ratio etc…
- Adequate Liquidity: Liquidity is one of the vital factors while making investment decision as some investments have a lock in period and can’t be redeemed within that period. For e.g. If you are investing in a Public Provident Fund (PPF) account or Equity Linked Saving Scheme (ELSS) Mutual Fund and are in need of money in next 1 year, then they aren’t the right investments for you no matter how good these investments are. Thus Prudent Asset Allocation will make sure that you have sufficient liquidity to pay for your financial goals as and when required. I know many of my friends and clients who over bought equities in order to generate good returns and in the Month of Apr 2020, when the Equity Market crashed were taken aback as they were not able to generate cash by selling Equities as they were not worth selling at that time.
Defining an optimal asset allocation is not as easy as it might seem to you, because you need to take into account, host of factors to reap the benefits of prudent asset allocation. But once prudent asset allocation is in place, you can be rest assured that you will earn adequate return, minimize risk and taxes, have sufficiently liquidity and even achieve your financial goals.