There is no single solution for allocating assets, as individual investors require individual solutions. That makes an asset allocation plan the most important aspect of your investment. A well-constructed asset allocation plan acts as a shield that will protect your wealth during uncertain economic conditions and market volatility. It can reduce the volatility of your portfolio and increase returns at the same time.
Here are the factors that you must consider when planning for asset allocation:
If you are a young investor (20 to 30 years old), then you should consider allocating a large percentage of your portfolio in risky assets, such as equities. Being young gives you ample time and opportunities to recover from any possible setbacks in the value of your portfolio.
If you belong to the middle age group (30 to 55 years old), then you should aim to create a moderately risky portfolio and avoid investing your entire savings in equities.
But if you are nearing retirement (55 years old and above), you should follow a highly conservative approach when planning your asset allocation and prefer debt or fixed-income instruments to preserve the principal amount.
Any appraisal of earnings will impact your discretionary income, as well as the amount of your investment. If you are employed and receiving a fixed monthly salary, you can allocate your savings systematically to both risky and safe instruments depending on your age. But if you are in the business industry, where profits and losses are not fixed in nature, you should allocate your assets with your future income-growth potential in mind. Take note that while higher profits can lead you to expand your business or invest in various financial instruments, a year of losses will directly affect your ability to invest.
If you want to be in good shape financially, it is imperative that you live within means and cut unnecessary expenses. By doing so, you will be able to save a large portion of your monthly earnings, which can be deployed in suitable asset classes. It will enable you to increase the net free cash available for asset allocation, which in turn if invested properly can help you increase your wealth and fulfill your financial goals.
Proximity to the goal
If you are many years away from your financial goals, you should ideally allocate most of your assets to equities and less towards fixed-income instruments. Take note that the concept of allocating funds to different asset classes based on how near you are to your goals helps not only in diversifying risks across asset classes, but also in rebalancing your portfolio when you are closer to achieving your goals. When you are drawing nearer to your goals in terms of number of years, say three years, you should start shifting to fixed-income instruments to avoid risky asset classes and safeguard your wealth.
Risk tolerance refers to how much an investor is willing and able to lose in hopes of getting a higher return in the future. If your willingness to take risk is high (aggressive), then you can skew your portfolio more toward the equity asset class. But if your willingness to take risk is low (conservative), then you should skew your portfolio toward the fixed income instruments. And if you are a moderate risk taker, then you can take a mix of equity and debt.
However, you should not take more risk just because you need a higher return. To minimize risk and maximize returns at the same time, the best course of action to take is to invest aggressively only when valuations are low. And the best approach to avoid huge portfolio drawdowns is to bypass overvalued assets.
Before allocating any funds, you should first analyze your existing portfolio. If you have high liabilities, even though you may be willing to take on high risk, you will still be considered a risk-averse investor. In this case, you will be advised to make safe investments only, as you cannot afford to let your investments suffer any setbacks due to market volatility. In addition, you should avoid taking loans or increasing liabilities to generate funds and invest in risk assets such as equities, as any losses might worsen your financial condition.
Once you have considered the factors discussed above and determined the right mix of stocks, bonds and other investments, it is time to implement your asset allocation plan. Keep in mind that asset allocation is not a one-time process; it is a life-long process of progression and fine-tuning. You must keep on reviewing your plan from time to time to ensure that it is aligned with your financial goals. Last but not the least, do not hesitate to seek help from a professional who corresponds with your investment philosophy.