Asset Allocation can be defined in common man’s language as not putting all your apples (Investments) in a single basket (Asset Class or Investible Instruments – Like Share, Mutual Fund, FD, Bonds, Real Estate), as one, if rotten, will infect or destroy all the other apples. Here we put each apple in different basket, now each apple is not linked with the other (i.e. One asset class is not correlated to the other) and if one or two apples gets rotten they won’t impact the others. Hence we are able to save few (Risk is balanced) in spite of damage issue (Loss or Negative Returns) in few apples (Investments) and thereby get few apples for consumption (average returns for our use) as a final outcome of adopting this method (Investment Strategy)
Importance of asset allocation
In Financial Market place, it never happens that all asset classes either give best or poor returns in a particular time frame. Rather a few give average returns, few above or below average returns, a few might be providing negative returns whereas a few may provide outstanding returns. Thus in totality, if we sum up, we get fairly better average returns provided we expose our total investible funds in different asset classes in different proportions for a given period of time. By diversifying our investments in different asset classes we not only earn fair returns but also minimize our risks as different asset classes are differently correlated and move in different directions. For instance, when equities may be up, gold investment might go down and vice versa. Hence it is always sensible to allocate investments in a mix of asset classes to reap highest possible returns with minimum possible risk.
All investments hold some level of risk. The reward for undertaking risk results in higher potential for better returns.
Factors affecting asset allocation
- Time of horizon:- represents the number of months or years an investor wants to invest to achieve his goal.
- Risk tolerance:- refers to an investor's willingness & ability to lose some/all of his/her original investment in anticipation of greater potential returns. Based on their willingness and ability, such investors are further sub- categorized as:-
- Aggressive Investors:- can take and are willing also for greater risks to earn higher returns. Their investments have greater exposure to equity i.e. Shares or equity oriented mutual funds
- Moderate Investors:- can take average risks (not too high- not too low) to earn average returns (not high-not too low). Such investor’s investment portfolio has exposure to both equity and debt products in equal proportions normally.
- Conservative Investors:- are risk averse and are not willing to take even little risk and always wants their investments to be safe along with its returns part. The major portion of such investor’s portfolio has investments in debt-instruments like Bonds, FD etc.
Risk vs returns:- No investment is risk free, each investment has some risk involved. The capacity and temperament to bear risk decides the possibilities to earn higher or better returns as everything has some cost. No gains without pains.
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