How to work with asset allocation and re-balancing in MFs?

Many people consider mutual funds as an effective way of investing and the recent inflows in mutual funds have proved that. However, if we watch intently we find that on an average, inflows are more tilted towards equity MFs. That said, people usually avoid getting into much of the technicalities and which is understandable the reason why people hire financial advisors. However, some things deserve your involvement as no one can understand your financial behaviour in a better way than you.
 
So that's why you should focus more on asset allocation and re-balancing? This is to be understood that you cannot reduce your risk by investing in just one asset class. Rather diversifying across asset classes helps you in reducing risk. Asset class means equity, debt, commodities, etc. and not stocks from various sectors which is the type of diversification which is strictly restricted to stock which is one of the elements of the broader asset class, i.e. equity. Not only asset allocation is important but also rebalancing your assets periodically is important. Rebalancing helps you to book profits from investments that have done exceptionally well and invested those profits in things that have merit but haven't done well.
 
Let us now understand how to do asset allocation and re-balancing? An illustration would be the better way to understand this. First things first, it is important to understand that as you near your financial goal or objective you need to change your asset allocation to complete debt allocation. The reason for this is that it becomes important for you to protect funds from losing capital as in short-term equities are volatile enough to drain your investments. So now the question would be when to move to complete debt? Three years to reach your financial objective or goal would be an ideal time frame you should consider complete debt allocation.

Getting back to our illustration, we assume that you have an investment time horizon of 10 years and you are an aggressive risk taker. Being an aggressive risk taker you invest 80 per cent in equity and 20 per cent in debt. So you should maintain this proportion till you reach 3 years prior to your goal and once you reach 3 years prior to the goal, shift complete 80 per cent of your equity investments to debt investments. Now during this course, i.e. 3 years prior to your goal you also need to rebalance and maintain the 80-20 equity-debt proportion. There would be the time when equity would perform better than debt and also there would be years when debt would be performing better than equity. Remember all the asset allocation must be in-line with your risk profile.