08/04/2019
Importance of Asset allocation, Rebalancing and Diversification
Sep 7 2018 5:46PM Mutual Fund
Consider this. You go to the kitchen to make your favourite dish for your family. Your kitchen is stocked with an array of spices. You know just the right amount of spices to make a dish that suits your palette. But what if you get the proportion wrong? Your favourite dish would be a disaster!
Now let’s talk about the investment portfolio.
Much like cooking without the right proportion of ingredients, investing randomly, without a proper asset allocation strategy, can be fraught with danger. Think of your favourite dish as your financial goals, asset class as the ingredients, and risk tolerance as your taste. If you don’t have the right mix of assets, your investment strategy can fall flat, just as the dish would!
What is asset allocation?
Asset allocation is an investment strategy dividing an investment portfolio among different asset classes, such as stocks, bonds, and cash.
Each asset class has different levels of return and risk, so each of them will behave differently over time depending on the market conditions.
The purpose of implementing an asset allocation strategy is to balance the payoff between risk and reward.
Determining your asset allocation is the most important decision that you make, because it will likely have more impact on your overall return than the selection of individual investments. So, try to pick the best mix of assets that has the highest probability of meeting your goal at a level of risk you can live with.
Asset allocation largely depends on the following factors:
Age
Financial goals
Investment time horizon
Risk appetite
Why do you need to tweak asset allocation?
Just allocating money to various investment avenues is not enough. You will also need to change your asset allocation strategy from time to time depending on the following situations:
When you get closer to your investment goal
When your risk tolerance level changes
In times of change in your financial situation
When you move closer to your retirement
However, if none of these situations arise, you will still need to tweak the asset allocation which is called rebalancing of the portfolio.
Rebalancing of portfolio- Why is it important?
Rebalancing is the process of bringing your portfolio back to your original asset allocation mix. You should consider rebalancing your portfolio once every year. If you don't rebalance your portfolio and get it back to the original mix, you may be at the risk of achieving your financial goals on time.
There are three different ways in which you can rebalance your portfolio:
Selling off investments from the over-weighted asset class and using the proceeds to purchase investments in an under-weighted asset class.
Make fresh investments in under-weighted asset class.
In case of continuous contributions to the portfolio, alter your contributions so that more investments go to under-weighted asset class until your portfolio is back to its original balance.
Before you rebalance your portfolio, make sure your financial outlook and investment objectives have not changed. In case your investment objectives have altered; you will be required to change the asset allocation accordingly.
Diversification and its merits
"Don't put all your eggs in one basket." Is what diversification means. The strategy involves spreading your money among various investments option in the hope that if one investment loses money, the other investments will more than make up for those losses.
Ideally, a well-diversified portfolio should be diversified at two levels:
Between asset classes i.e Equity, Debt, Commodities and cash.
Within asset classes i.e. Largecap, Midcap, Smallcap, etc in case of Equity oriented funds and Liquid, Short term, income funds, etc in case of debt funds.
Asset Allocation and Diversification are not synonymous
Many investors make the mistake of thinking that by implementing an asset allocation strategy will automatically diversify the portfolio. To be adequately diversified, you must need representation across investment categories. This will prevent your portfolio from plunging downwards due to the underperformance of one asset class.
To conclude, it is fair to say that the right asset allocation will ensure you are in the right position in the risk return spectrum to meet your goals. Diversification is an additional step in your investment strategy to prevent your portfolio suffering from the risk of loss due to the underperformance of one particular investment class thus preventing you from meeting your goals.
