Four steps to asset allocation

Asset allocation is the most important decision you will ever make for your investments and in the opinion of experts, asset allocation is the most important determinant of the Long Term returns generated by a portfolio

First, it is imperative to understand there is no fixed formula for arriving at the perfect asset allocation. The idea behind this exercise is to help build an optimum asset allocation based on an individual's needs, which is to be assessed on a case-to case basis.
Here are four steps to help in asset allocation.

Step 1: Understand different asset classes

It is important to understand that the underlying intention of asset allocation is to build an investment portfolio with asset classes that are not correlated to each other--if one asset class is losing, the other(s) should ideally gain. Only then, will you be able to diversify the risk of the overall portfolio.

Investors often confuse the concept of asset allocation with mere diversification. For instance, an investor may have diversified his portfolio between stocks and mutual funds. But if he has invested in equity mutual funds, he is still entirely invested in stocks.

Thus, learning about various asset classes and their risk-returns profiles can help you create an optimum asset allocation. Here, we discuss three broad asset classes: equity, debt, and cash and equivalents.

Equity: The most volatile asset class in the short term but the one with the potential to provide the most returns over the long term. Equity shares and equity mutual funds are typical instruments available to investors under this head. If you cannot handle short term market fluctuations and are afraid of putting your capital at stake, it is best for you to have lower exposure to equities.

Debt: Also, referred to as fixed income, it provides more predictable and less risky returns, with the downside that the returns may not be spectacular. The main objective behind investing in debt is to take lower risk (than equities) and earn lower returns. Expectedly, this investment option is suited for an investor, who does not intend to take much risk and an intends to better predict his returns. Fixed deposits, small savings schemes, public provident fund and debt mutual funds are some of the instruments available to investors.

Cash and equivalents: Liquid cash in hand or balance in your savings bank account can be classified under this category. Though the returns from this asset class can be very less (in fact, the least among all asset classes), it has its own importance, especially in times of an emergency, as it is the most liquid of all classes. Some of the options under this asset class are savings bank account, liquid funds and cash.

Besides these, there are also other asset categories like real estate and precious metals, to name a few. Investors should also consider including these asset categories within a portfolio. But as always, before you make any investments, you should understand the risks associated with each of them and make sure the risks are appropriate for you.

Step 2: Who am I?

After having understood the various asset classes and risks associated with them, what follows next is answering a fundamental, yet important question: What is my risk tolerance level? This, in turn, would determine the exposure towards each of these asset classes.

The answer to this question is derived from your age, income and financial goals/requirements. Being excessively exposed to any particular asset class without understanding one's risk appetite and the risk associated with the asset class can be a recipe for disaster.

Broadly speaking, there are three types of investors depending on the risk profile: aggressive, moderate and conservative. An aggressive investor is one who has a higher risk tolerance level. In other words, he can invest predominantly into riskier asset classes such as equities and related products. A moderate investor looks for stability along with some growth in his portfolio while taking moderating levels of risk. Lastly, a conservative investor is clearly risk averse and is willing to give up on high returns in order to lower his risk by sticking to those investment avenues which offer assured returns and/or capital protection.

Chasing higher returns while ignoring the associated risk will take you nowhere. In the same vein, being unduly risk-averse when one's goals and lifestyle demand higher risk may not be a smart move either.

Step 3: Define your requirements

If you are planning for regular income post-retirement, you may decide on the fixed amount you would like to receive every year or month and plan your present investments accordingly. You also have to estimate your future requirements and whether you want to leave some accumulated wealth for your loved ones and plan accordingly.

Step 4: Building a portfolio

After identifying your financial needs/requirements, on the next step is to build your portfolio. Expectedly, the portfolio needs to be customized according to the investor’s needs. However, some investing thumb rules can serve as good starting points. For instance: an aggressive investor can invest around 50-70% in equities and the remaining in debt. Similarly, a moderate investor may have 40% -60% in equities with the remaining in debt and cash/cash equivalents. And a conservative investor should typically have higher exposure towards fixed income instruments i.e nearly 60% - 80% with the remaining in cash with only a minimum in equity. Expectedly, over a period of time, as needs change, so will the portfolio. For instance, a young investor with minimal responsibilities might be game for an aggressive portfolio, however as the same investor grows older and takes up certain responsibilities, he might turn towards a different portfolio.

Step 5: Portfolio Review

It is important to note that with changing times your goals or financial requirements will keep changing. Accordingly you will also have to review your portfolio and rebalance it at every stage of your life. At the same time reviewing is necessary to check whether the built portfolio is working for you as expected and if not, then there might be a need to relook at the components

Asset allocation is the most important decision you will ever make for your investments and with that in mind, you may want to consider consulting a financial advisor to help you determine your asset allocation and for constructing an investment portfolio as well.