Asset Allocation: The magic formula for your portfolio
InCred Wealth June 19, 2020
Achieving a healthy body and mind is on everyone’s agenda. For the former, we try to follow a good and balanced diet plan which has a mix of carbohydrates, proteins, vitamins and fats. For the latter, we try to exercise regularly and practice yoga. If our diet is skewed too much towards any one or two of the above, then it is unlikely that we will get the desired nourishment and health benefits. Similarly, if we exercise too much or don’t introduce variations in our exercise regime then it is likely that we might burn out or hurt ourselves. The key is to create a balanced mix. Just like it is important to pay attention to your mind and body, it is equally important to maintain a healthy investment portfolio. But how do you do that? The answer lies in creating a diversified investment portfolio through a customised and robust asset allocation strategy. Simply put, asset allocation is a portfolio building strategy that aims to create an optimal balance between risk and reward by spreading the portfolio’s investments across multiple asset classes. Having the right balance—the optimal asset allocation ensures that you are not heavily invested in one asset class that could see a sharp decline and drag down your portfolio value with it.
Why is asset allocation important?
The principle of asset allocation is tethered to a simple philosophy – create a portfolio of multiple assets that have little or no correlation with each other such that they have varying responses to the same events/developments. In the case of sudden and impactful negative events, it is likely that some of the assets in the portfolio will witness a steep price correction. However, if the assets in your portfolio have minimal correlation, then there will be a part of your portfolio which will either not react to the event or move higher, thus balancing out the negative movement. Hence, asset allocation insulates your portfolio from extreme market movements. In addition to mitigating overall portfolio volatility, pursuing an asset allocation strategy can accrue multiple other benefits to an investor as well.
- If you stay tethered to your asset allocation strategy, then you do not need to constantly time the markets. In the case of sharp movements, all you need to do is simply rebalance your portfolio to reflect the pre-determined allocation.
- Most investors succumb to behavioural biases that encourage them to allocate a disproportionate amount to any one asset class due to higher past returns or other external factors or herd mentality. However, by adhering to an asset allocation strategy, investors can avoid making rash portfolio decisions.
Optimising your asset allocation strategy
To make asset allocation work for you, it is imperative that you consider your own specific circumstances to arrive at a customised asset allocation strategy. The three key drivers of your asset allocation strategy should be your return requirements, risk profile and investment time horizon. If you have a longer time horizon, say more than 3 years and fall in the category of ‘above average risk profile” then you can consider a larger allocation to risk assets like equities. On the other hand, even if you fall in the category of ‘above average risk profile’ but have a shorter investment time horizon of say 1 years, then it would be better to skew your portfolio towards low to medium risk instruments. The end goal is to create an investment portfolio that generates the required return and is well aligned with your risk profile. Asset allocation is a very simple and time-tested approach to creating a well-diversified portfolio that minimises risk while maximising returns, precludes the need for timing the market and inculcates investment discipline. Remember, one of the most important things in investing is asset allocation. Asset allocation is the primary determinant (explains 93.6%* of the variation) of a portfolio’s return variability, with security selection and market timing (together, active management) playing minor roles.
* “Determinants of Portfolio Performance” by Gary P. Brinson, CFA, Randolph Hood, and Gilbert L. Beebower