Have you paid attention to your investment portfolio? Every investment portfolio needs to have a mix of asset classes so that there is an element of balance. This is akin to the famous idiom of not putting all your eggs in a single basket. The principle of asset allocation applies to mutual fund investments as well.
Before you wonder what an asset class means, here’s a simple explanation. An asset class is a set of financial instruments with similar attributes. Examples of asset classes include equity, fixed income /debt, cash or gold. Real estate and commodities are also referred to as asset classes. Each of these asset classes come with their own advantages and disadvantages. For instance, equity is a high risk and high-return investment, while fixed income or debt instruments are low to medium-risk asset classes. Gold is known as an asset class that helps you hedge or offset the losses from another asset class. Gold is used as a hedge instrument.
What is asset allocation as a strategy, and what are its benefits?
An asset allocation strategy balances the positives and negatives of each asset class, and ensures that an investor has the appropriate exposure to risk and adequate protection from volatility. A good strategy helps you tap into the positive attributes of every asset class.
The benefits of using asset allocation include:
- Diversification: Since asset allocation involves investing in different classes, there is the key element of diversification which plays a role in reducing risks. Different asset classes are impacted differently by market forces or the economy, so you won’t be badly hit by risks inherent in one risk type. If you were to purely invest in stocks, and if the stock markets crash like the 2008 collapse, you would have to lose all your investment. If you had invested in debt/fixed income assets, you would have reaped the positives of that asset class which would have protected you from the risk that equities bring.
- Long-term investing: Asset allocation helps you think long-term and not base your investments on temporary market volatility. On the back of your portfolio following the asset allocation principle, your investments are not overly affected by fluctuations in the market.
- Discipline: Thanks to thinking long-term and the diversification in your portfolio, there is an element of discipline in your investing. Asset allocation helps you focus on your goals and the assets that suit your goals.
- Better returns: Diversification entails that if you are exposed to various asset classes over the long term horizon, thus you are likely to outperform the portfolio with a single asset class. This is achieved by cushioning your portfolio with an array of assets against market drawdowns in one asset class.
(Source: Economic Times*)
How does one employ asset allocation in your mutual fund investing?
Keep an eye on asset allocation when you invest in mutual funds. There are different types of mutual funds, including equity mutual funds, debt mutual funds and hybrid funds. Equity funds invest a major part of their wealth in equity while investing a minor portion in debt instruments. Debt mutual funds invest in fixed income instruments like government bonds and securities. Hybrid or asset allocation funds are those that invest in a mix of asset classes including equity and debt-related instruments. These funds are further classified into dynamic asset allocation funds and balanced funds. In a dynamic asset allocation fund (DAAF), the asset percentage/proportion is constantly changing in line with market variations. Balanced funds typically invest 65-80% of their portfolio in equity and the remaining in debt.
Asset allocation process
One of the most common asset allocation thumb rule is that your holding in equity should be 100 minus your age. So, if you are 40, you could invest 60 percent in equity and the remaining in debt. There is also a Rule of 110, which works similarly.
However, these are thumb rules. The factor that one needs to keep in mind while investing is risk tolerance. You would also need to assess your financial goals, your net worth, earning capacity, your commitments and then take a call rather than simply relying on age. You would also need to look at the time horizon that you would wish to stay invested in.
Mutual funds have an inherent element of diversification and are the easiest way to achieve asset allocation as well. Even within an asset class, you can achieve a certain amount of diversification — for instance, if you are investing in equity mutual funds, you could pick one that has a mix of investments in small, large and mid-cap companies.
In conclusion, asset allocation is a strategy that helps you reap the benefits of various asset classes while staying protected against market volatility. Diversification helps you balance the risks and rewards of mutual fund investing. Just look up for mutual fund schemes, whether they are balanced funds, equity mutual funds or debt funds on Tata Capital Wealth portal, and pick one that helps you meet your financial goals.