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Asset allocation is one of the most underestimated tools for building long-term wealth but is not understood well enough by most investors.

In the last few years, campaigns such as Mutual Fund Sahi Hai have done their bit in demystifying market investments. Additionally, significant technology-driven simplification has taken place the last few years, with paper-based transactions moving largely online, making access radically easier. Both these steps have led to a wave of young investors entering the markets, many of them through the mutual fund route.

While this is good news, there is also an overload of information that this digital explosion has swamped investors with. Increased competition has also led manufacturers (AMCs or asset management companies) into launching a variety of products in a bid to capture new niches.

And with markets now at all-time highs, one of the jargon that is on top of the pile is “Asset Allocation.” Every newsletter or interview, whether of your fund manager, your broker or your bank refers to this term and advises investors to heed market valuations and “stick to their asset allocation.”

An average customer may not be aware of what this term means or, worse, may have a wrong understanding of it.

That said, Asset Allocation is one of the most underestimated tools for building long-term wealth, but not understood well enough by most investors.

What is Asset Allocation? Why is it needed?

-Asset Allocation simply means allocating your investment monies across varied asset classes. In its simplest form, Asset Allocation usually measures the share of investments across equity and debt, the predominant two asset classes.

-The first reason why Asset Allocation is needed is because different asset classes are usually not correlated. So when one goes down, the other holds up, in a way acting like a cushion on your overall portfolio. In simple terms, split your portfolio across Equity and Debt so that the portfolio is at all times, “balanced”

-The second reason why Asset Allocation is needed is to take care of an investor’s long-term needs (growth assets like equity) as well as short-term needs (income assets like debt). Different asset classes have different risk-return characteristics and hence must be chosen appropriate to your investing need.

What does Asset Allocation actually do?

-Since every investor’s needs are different, it follows that every investor’s asset allocation will be unique. Simply put, an investor’s Asset Allocation defines the optimum risk that an investor needs to take in order to achieve his or her goals.

-Asset Allocation therefore acts as a pressure valve on your overall portfolio, ensuring that every time the risk in your portfolio exceeds the risk that you need to meet your goals, “switching ON the Asset Allocation valve” can bring your portfolio back to the optimum risk level, ensuring that you are not taking any more risk than needed.

-During rising markets, Asset Allocation can help you move money out of growth assets in a planned way, and similarly during falling markets, it can help you re-enter markets systematically

How do I decide my Asset Allocation?

-Your unique Asset Allocation is a function of your specific financial goals, time horizons and risk profile

-Therefore, at the root of determining your Asset Allocation is being clear about why you are investing and having an overall plan

-A good financial planner helps you determine your desired long-term (also called “strategic”) Asset Allocation as part of the plan and also uses Asset Allocation during plan reviews to help you grow your wealth with just enough risk so that you can meet your goals

-If you are a DIY investor, it is something that you will need to arrive at on your own, by understanding why you are investing (goals), when you need the money (time horizon) and how much risk you are able and willing to take (risk capacity & appetite).

How can I use Asset Allocation effectively?

-Asset Allocation essentially gives you a straight-line path for you to build your wealth to meet your goals. But unfortunately, markets do not move in a straight line and hence your portfolio asset allocation will swing depending on how markets are performing

-Periodic (ideally once in six to twelve months) reviews of your portfolio with your planner will help you determine whether your portfolio needs “re-balancing”

-So, when reputed fund managers say “stick to your asset allocation” during these times, they essentially mean: use these opportunities to rebalance your portfolio to your long-term asset allocation; if your portfolio has moved significantly away from it and if the risk is much higher than you need to take to meet your goals

What is Asset Allocation “not”?

-It is common to confuse Diversification with Asset Allocation. Asset Allocation is optimum exposure to non-correlated asset classes. Diversification is adequate exposure within an asset class.

-Importantly, “sticking to your Asset Allocation” does not mean “investing in Balanced Advantage funds”. BAFs are nothing but vehicles that automatically adjust their exposure to various asset classes (usually Equity & Debt) depending on pre-defined models.

-Simply put, investing in a BAF is akin to riding an automatic car rather than a one with a manual gear-shift. That said, it does not mean that this automatic car is ideal for you and the destination you need to reach.

Hence, determine your desired Asset Allocation to help you reach your financial dreams, align your investments accordingly and periodically review and re-balance, to ensure that you are taking adequate but not unnecessarily more risk in order to achieve your goals.