How to get your asset allocation right

One of the least appreciated facts among most of the investors is that the long-term investment result of their portfolio is mostly determined by the composition of assets or asset mix in your portfolio.

As the investment horizon gets longer, asset allocation emerges as the dominant factor, driving investment results. Therefore, when you go for financial planning, concentrate, and focus on getting your asset allocation right.

What is asset allocation?

Asset allocation is the process of deciding how to divide your investment across several asset categories. The asset categories here can be equity, debt, or gold (or even real estate, commodities, etc). The goal of asset allocation is to minimise volatility by investing in different asset classes. The process here involves dividing your investment among asset categories that do not at all respond to the same market forces in the same way at the same time. The recent example can be gold, which was performing better when equity was falling.

How different assets behave

The performance of different asset classes is unpredictable; however, what is predictable is that there is always a change in the best performing asset class. Winners keep on rotating each year when it comes to investments. What may be the best asset class today may not be the same tomorrow. This is because different asset classes react to economic development in a different manner. Even within an asset class, there are sub-asset classes that behave differently at a given period of time.

The equity market tends to generally perform well in expansionary economies, i.e. lower interest rates lead to more money supply and increasing demand. Within this economic expansion period, at a different stage of economic activity, the different sub-asset class performs. For example, in the late stage of economic expansion, small-cap dedicated stocks perform better than large and mid-cap stocks. On the other hand, bonds tend to generally perform well in contracting economies.

Therefore, if your investments are concentrated in a particular asset class that may not be performing very well at a particular point in time, the entire portfolio is bound to be impacted. Similarly, chances are high that your investments may perform very well in case you are invested in an asset class that is favoured by the economic environment. Nevertheless, it will be a roller coaster ride. Having a diversified portfolio with holdings across asset classes ensures that the gains in a particular asset class will help offset some of the losses in another asset class thereby, reducing the negative impact of the laggard on the overall portfolio and smooth investing experience.

How to go about asset allocation

The number of asset categories and the percentage of portfolio you allocate will depend on your tolerance for risk, investment goals, and investment horizon. There are some simple thumb rules that you should follow while asset allocation such as your age, which should be invested in debt and the rest in equity. Therefore, if you are 30 years old, you can invest 30 per cent in debt and 70 per cent (100-30) in equity. You can also seek the help of a financial planner, who will help you reach the optimal asset allocation as per your financial goals.