By Anu Jain, Head - Equity Brokerage, IIFL Wealth
Wealth needs to be earned, nurtured, and preserved. The best way to achieve the first is to work hard and work smart. The best way to achieve the last two is to craft a customised asset allocation strategy that can protect your portfolio and generate the necessary returns.
An asset allocation strategy entails spreading your investment portfolio across multiple asset classes such that sharp movements in any one asset class do not have an excessively large impact on your overall portfolio risk and returns. However, when you invest in multiple asset classes you must ensure that they have little to negative correlation to each other. This means that they respond differently to the same set of events or developments.
While there are several factors that must be taken into consideration while crafting an asset allocation strategy, there are a few that just cannot be ignored.
It’s All About The Risk
To ensure that asset allocation is done right, you need to be aware of your own risk profile and of the risk inherent in various investments. Your risk profile indicates your ability and willingness to take a risk. If you have an aggressive risk profile then you can take higher levels of risk and if you have a risk-averse profile then you are probably comfortable with very low levels of risk. When we talk about investments, generally equities and alternatives are considered higher on the risk curve compared to fixed-income investments. What does this translate into when it comes to asset allocation? Basically, if you have an aggressive risk profile then you should consider having a higher exposure to equities and if you have a risk-averse profile then you should have minimal exposure to equities and higher exposure to fixed-income investments.
Age Is Definitely More Than Just A Number
Your age plays an important role in your asset allocation strategy. Age is relevant for two reasons. One, it tells you how much time you have to invest, reach your goal, and maybe recover from intermittent losses and two, it impacts your willingness and ability to take a risk. If you are in your twenties or early thirties, then you are well-positioned to allocate a higher amount to risky assets such as equities. This is because equities, though volatile in the short term, can create significant wealth over the long term. Since you have the advantage of time, you can afford to take more risk. If you are in your late 40s and 50s you probably have a number of goals lined up and thus cannot put your capital at risk. Accordingly, your exposure to equities should reduce. Further, if you are on the other side of 60, then you should ideally have a very little allocation to equities. This is because, as you cross 60, it is possible that your sources of income might dwindle, thereby impacting your ability to take a risk.
Investment Time Horizon Is Important
One of the main purposes of having an asset allocation strategy is to ensure that you can achieve your various financial goals. If you have a long-term investment time horizon and are many years away from your goal, then you can have a higher allocation towards equities and a relatively lower allocation to fixed-income investments. On the other hand, if you have a financial goal that needs to be achieved in the next two to three years, then you cannot afford to put your capital at risk. Thus, you need to allocate largely to fixed-income investments with very little or no exposure to equity investments. Another factor to consider is nearness to your goals. Even if you have invested in equities for a long-term goal, you must shift allocation to safer debt instruments as you reach closer to your goals. This will ensure that you are able to secure the returns that you have generated to achieve your goals.
Once you have the above three in place, you are well on your way to improving your portfolio’s risk-adjusted.