Every investor needs a strategy for allocating assets. This strategy represents a framework for making decisions about how much of your investment portfolio will be allocated to various investment categories, such as equities, fixed income and cash instruments. To help you better understand the importance of an asset-allocation strategy, here are its potential benefits:
Lower investment risk
One of the primary means to reduce the risk of an investment portfolio is diversification across various asset classes. Since different investments are affected differently by economic events and market factors, owning different types of investments will help reduce the chance that a particular risk type will affect your portfolio adversely. If one investment is doing poorly, it will not compromise your entire portfolio.
Reduced portfolio volatility
Investing in a selection of securities spread across different asset classes can give your portfolio the kind of diversification that may help reduce volatility in turbulent times. And if you have a well-diversified portfolio, you will have opportunities for growth with less overall portfolio volatility.
It works this way: The volatility of a diversified portfolio depends on the volatility of its asset class components and, often, the correlation between their volatility is negative. Market conditions can make a particular asset class register significant appreciation while denting the value of another asset class. As such, the inclusion of asset classes with negative correlation offsets the losses from a falling asset class with the gains of the rising one.
Equities and debt instruments are an example of asset components with negative correlation. When the economy weakens and corporate profits decline, equity markets will fall. And when the central bank reduces the borrowing costs by reducing policy rules, bond prices will appreciate. Thus, if you have both equities and debt instruments in your investment portfolio, the capital appreciation of your debt component will offset the losses from the equity component.
Each asset class comes with a unique proposition. While some generate high returns (such as equities), others guarantee stability and certainty of income (such as fixed-income instruments). In a diversified portfolio with significant exposure to both equity and fixed income, the equity component will generate high returns for your portfolio while the debt component will provide stability when markets are volatile.
Ability to maintain adequate liquidity
The liquidity of an asset class refers to the ease of converting it into cash. It is one of the major considerations when making investment decisions. An asset-allocation strategy will help you maintain adequate liquidity in your portfolio by designating a portion of it in safer asset classes for meeting short-term goals and even financial emergencies.
Do not put your emergency fund in equity funds, or you may be forced to redeem them at a loss for meeting financial exigencies during market corrections. Instead, to ensure capital protection, put your emergency fund in ultra-short and short-term debt funds.
Rebalancing is the review of the current asset allocation to identify and correct any deviation from the original strategy.
If you have an asset-allocation strategy in place, it will help you determine your optimum asset mix and rebalance it according to the time horizon of your financial goals. Take equities as an example. As they can be very volatile in the short term, you should consider redeeming equity investments made for financial goals nearing maturity and putting them in debt funds to consolidate your gains.
Equities, on the other hand, outperform other asset classes over the long term. The asset allocation for long-term financial goals can continue remaining equity-heavy, as it will get more time to recover from the volatility of equity markets.
A key factor in the success of an asset-allocation strategy is the commitment to a periodic portfolio rebalancing. You should set ranges for each investment category, say plus or minus 5% away from the target allocation. And make sure to rebalance the portfolio when one or more categories fall outside of those ranges.
Greater investment discipline
It is almost impossible to time the performance cycles of different investment categories. But establishing an asset-allocation strategy and rebalancing regularly to preserve that strategy introduce greater discipline into an investment plan. If you have a solid investment plan and stick to it, then your chances of achieving your long-term investment objectives will increase.
Knowing the benefits of asset allocation is good, but knowing what strategy to use is better. To help you get started, we have listed the most commonly used asset-allocation strategies in a previous article. Your choice will, of course, depend on a variety of factors unique to your situation, including investment period, investment preferences, return expectations and risk tolerance. Once you have chosen a strategy, stay focused on it to avoid investing in assets that will not help you reach your financial goals.