Many of us have come across asset allocation, even if we do not recognize the term.
Let me tell you how you know it:
You may have noticed that most elderly persons do not keep all their cash in one place. They divide it by keeping some in the front pocket, some in their bag, and the rest in their purse.
This is a type of asset allocation 🙂
By spreading money in different places, it minimizes the risk of loss in theft or any other mishap. Similarly, allocating your investment across various assets is also important to minimize risk exposure.
What Is Asset Allocation In Investing?
Asset allocation is a strategy which requires you to divide your investment between various assets and asset classes.
Each class will carry a different level of risk and returns and behave differently over a period.
This strategy is a broader view of diversification. Any pie chart that appears on your financial statements is probably your portfolio’s asset allocation.
Major Asset Classes:
- Stocks – are high-risk, high-return investments. Equity mutual funds and ETF’s fall under this category. If you are willing to take the risk, there are chances that you may earn positive returns.
- Bonds – are less riskier when compared to stocks. Bonds offer a fixed interest, depending on the asset. And are a good option if you are seeking stability and income.
- Money Market – includes cash and cash equivalents such as certificates, deposits, securities, etc. They usually have a guarantee on return of capital but yield meager returns.
- Alternative assets – Any asset that does not fall under the above categories are considered as alternate assets. These assets are non-correlated to the market swings and economic crashes. Meaning, these assets tend to perform well even when stock markets crash and interest rates fluctuate. Cryptocurrencies are a suitable example of an alternative asset class.
Example of Asset Allocation
Let us say Sameera wants to create a financial cover for her retirement.
She has decided to invest in ₹1,00,000 for ten years. Her portfolio manager has advised her to allocate her assets across stocks, bonds, fixed income, and cryptocurrencies in the ratio of 40/30/20/10, respectively.
In this case, her portfolio may look like this:
Factors Affecting Asset Allocation
When deciding on a portfolio, certain factors influence how you choose the asset classes and their ratio. These factors include your goals, time horizon, and risk tolerance, etc.
- Goals: Each person has different needs and desires. One may want to invest for retirement, while another may invest in their child’s college, or someone would want it for a vacation. Your portfolio is shaped based on your goals.
- Risk Tolerance: How much amount you are willing to lose in your investment now in anticipation of making greater returns in the future defines your risk tolerance. Some may have a higher tolerance for risk, while others may fear to take risks.
- Time Horizon: This factor determines how long you are willing to be invested in an asset. Your investments may be short term or long term. Different time horizons depend on your goals and risk tolerance. While goals such as buying a laptop require a short time, investments for purchasing property may be a long time horizon.
Why Should You Not Ignore Asset Allocation?
You can mitigate overall portfolio risk by following the asset allocation strategy. Stocks, bonds, and alternative asset markets do not move parallelly. If one asset outperforms the market at a given period, another investment may underperform, and the circle goes on.
Let us say you have invested in both stocks and Bitcoin at the start of this year (2020).
When the government announced a lockdown, the stock market started crashing, bringing the value of your stock investments down. At the same time, the price of Bitcoin rose by about 100%.
In this case, the outperformance of Bitcoin would have nullified the underperforming stock value. This way, your portfolio as a whole would have been exposed to minimum risk.
Asset allocation plays a significant role in reaching your financial goals.
If you are willing to take excessive risk, you may have a chance of losing your investment. On the contrary, if you are not willing to take any risk, you may not generate enough returns.
To balance both, your portfolio has to be well balanced between various asset classes factoring in the risk component.
Cryptocurrency – A Useful Tool In Asset Allocation
Cryptocurrencies such as Bitcoin are an effective tool to balance your portfolio.
You may think: “Cryptocurrencies neither have intrinsic value nor pay dividends, then how?”
You may be familiar with the fact that Bitcoin has yielded multiple fold returns since inception. This is because ‘there’s a limited supply of it, making it truly an inflation-proof asset.’
Research shows that even if your portfolio contains 1% of cryptocurrencies, it is enough to balance the risk.
Though they are highly volatile, 1% may not do much harm to the portfolio. However, when the market underperforms, returns from cryptocurrencies may be enough to cover other assets’ underperformance.
In a nutshell, as it is essential to eat a balanced diet for a healthy life. Similarly, it is vital to maintain a healthy balance of assets in your portfolio to keep your investment healthy.
Knowledge of asset allocation helps you do that, and when this combines with goal-based investing, you gain superpowers to achieve your financial dreams.
So keep investing !!
[su_note] KuberVerse is an educational initiative. Anything expressed here directly or indirectly is not investment advice. And we ask you to do your own research before investing. [/su_note]
Disclaimer : Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions. The information provided in this post is not to be considered as investment/financial advice from CoinSwitch. Any action taken upon the information shall be at user's own risk.
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