Factors to decide Asset Allocation Strategy

Asset Allocation is one of the crucial steps in preparing your portfolio. Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor’s risk tolerance, goals and investment time frame. Asset allocation is based on the principle that different assets perform differently in different market and economic conditions.

Different types of asset allocation strategies are as follows:-

• Strategic Asset Allocation
• Tactical Asset Allocation
• Dynamic Asset Allocation
• Constant Weighting Asset Allocation

You need to remember the factors that would affect your asset allocation strategy. Some of them are as follows:-

1] Time Horizon –

Basically, your investments should be matched with your need for the money.  A long term investment horizon means you can invest in assets such as equities because you have time on your side. A short term investment horizon requires more stable and liquid investments.

Longer time horizon–higher risk taking capability. It means, longer the time horizon higher the amount of risk you can afford to take. Longer time horizon leads to increased risk taking capability and higher allocation towards riskier assets classes. For example, if you have 30 years to reach a goal (like retirement), a market fluctuation that causes the value of your investments in the early years if investment to sink is not as big a danger, as you have a long time to recover.

How soon you intend to start taking money from your portfolio may also influence the type of investments you choose. For example, if you need to withdraw money relatively soon, you should consider having a higher percentage of your investments in cash or liquid.

2] Risk Tolerance –

It is common in the financial market to base your asset allocation strategy on risk capacity, risk tolerance, and need for risk (how much return you need). Real risk is losing your principal. Everyone should be intolerant towards losing their principal. You don’t take more risk just because you believe you need a high return.

Successful value investors use their asset allocation plan to reduce risk by only investing when the odds are heavily in their favor. Balancing the risk you are willing to accept with the investment returns you need or want will help determine your asset allocation. You should understand the risks associated with investing in each asset class.

Depending upon the risk tolerance, one can choose from the following risk profiles which suits best the asset allocation of a person:-

1] Secure –

Investment allocation– 0% Equity & 100% Debt

Expected returns– 7%

Investment options– a) Equity: No Investment

b) Debt: FDs, Tax free bonds, Debt funds, etc

2] Conservative –

Investment allocation– 20% Equity & 80% Debt

Expected returns- 8-9%

Investment options– a) Equity: Large Cap Funds

b) Debt: FDs, Tax free bonds, Debt funds, etc

3] Moderate –

Investment allocation– 50% Equity & 50% Debt

Expected returns– 10%

Investment options– a) Equity: Large cap funds, Diversified equity funds, Hybrid funds

b) Debt: FDs, Tax free bonds, Debt funds, etc

4] Growth –

Investment allocation– 80% Equity & 20% Debt

Expected returns– 12%

Investment options– a) Equity: Diversified equity funds, stocks

b) Debt: Debt funds, Government securities

5] Aggressive –

Investment allocation– 100% Equity & 0% Debt

Expected returns– 13-14%

Investment options– a) Equity: Diversified funds, stocks

b) Debt: No Investment

3] Financial Situation –

You have to think about your current situation and the lifestyle you would like to lead in your later years. Putting asset allocation into practice means deciding about which assets to buy and what proportion of each asset to hold. The first thing to consider is your present financial situation and how much you can afford to invest. Next, you need to think about why you’re investing. For many people, investing for the long term is about providing money for retirement. So you have to think about when you might like to retire, and what you would like to do during your retirement.

An individual who is in higher income bracket can obviously tolerate higher risks. As he is earning more, can have more investible amount, hence can invest more in riskier assets. The income here is not only the salary but also include his assets and liabilities. If your annual growth rate in income is high, your risk taking capability is more and can opt for riskier asset classes in his or her asset allocations.