Meaning of Asset Allocation, and its types
All of us invest to achieve capital appreciation and optimum results. We aim to grow our wealth without eroding our capital. To this end, we must implement strategies to get maximum returns with minimum risks. We can do this by allocating assets across various asset classes. This article explains the meaning of Asset Allocation and its significance in mutual funds and financial planning.
Asset Allocation is a way to distribute funds across several asset classes to balance the risk and return ratios of an investment portfolio. A fund house gathers money from investors and allocates the funds to different assets. Fund managers typically invest assets across various asset classes, including equities, fixed-income securities, cash and cash equivalents, real estate, etc., to increase your estimated returns while minimising risks.
Instead of allocating all your funds in a pure asset class, fund managers invest them in multiple asset classes. For example, equities underperform when the stock market is on the decline. However, fixed-income securities are not significantly impacted by market fluctuations. When you have funds invested in both equity and debt securities, the two complement each other during unfavourable market conditions. As such, diversifying your portfolio reduces the overall risk.
India’s market Regular SEBI mandates the percentage of equity-to-debt asset allocation. However, in the case of Dynamic Asset Allocation, fund managers can freely adjust the ratio based on market conditions. Fund managers generally gravitate to debt funds to minimise losses during a bearish trend. Conversely, they allocate more assets in equity securities during a bullish market.
In Constant-Weighting, also known as Strategic Asset Allocation, fund managers usually follow the buy and hold strategy. For example, if share prices are falling, they buy more of those stocks, and contrariwise. That said, per SEBI norms, the proportions of the asset classes must not deviate more than 5%.
Tactical Asset Allocation involves a substantial knowledge of the market. Fund managers can stray from long term Asset Allocations and take advantage of market volatility. For instance, you invest in a mutual fund that invests 65% in equity and 35% in debt. When you think the market is in your favour, you can shift the proportion to 75% - 25%. The extra 10% will boost your overall equity returns.
In the age-based investment strategy, you subtract your age from 100 and invest that number as a percentage in equity funds. If your age is 25 years, you subtract 25 from 100 and get 75. Hence, financial advisors recommend investing 75% in equities and the remaining in debt assets.
Tactical Asset Allocation across asset classes empowers you to increase your profit potential while considerably mitigating risks. However, market conditions are unpredictable, and even the best-laid plans can fall through. Thus, it is crucial to review your investments periodically and make the necessary adjustments, including refining your asset allocation strategies.
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*Disclaimer: This article is for information purposes only. We recommend you get in touch with your income tax advisor or CA for expert advice.