Benefits of Asset Allocation

Some lessons you learn early on from your life, Asset Allocation is one such lesson which I learned from my mother during my teenage. She used to tell me that in the preparation of a Khichdi proportion is very important. If you mix ingredients in correct proportions then it tastes great, if you go off by few percentages then it is eatable but does not test great, and if you mess up your proportions then you end you making something which does not taste great and not eatable as well.

Asset Allocation is a similar concept which gets applied to Personal Finance. First, let’s read it’s definition from Wikipedia:

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.

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Image Credits Arbor Investment Planner

There are many strategies to implement based on theory, but for sake of simplicity to understand and implement let’s take “Constant-Weighting Asset Allocation” strategy. “Constant-Weighting Asset Allocation” strategy suggest that you define a weight for each asset class and create your portfolio accordingly, and rebalanced it when you go off by several percentages, let’s say by 5%. The benefit of strategy is that it will guide you to buy asset when it’s price is low and sell asset when it’s price is high.

Let’s take few realistic scenarios. Usually, conservative people define a “Constant-Weighting” strategy like below.

Debt Allocation = Your Age.

Equity Allocation = 100 – Debt Allocation.

People having more aggressive approach may use Debt Allocation = Years of your age – (10 or 15 or 20). And, people having more conservative approach may use Debt Allocation = Years of your age + (5 or 10)

So, for someone (let’s call him Amit) who just started earning at age of 25 will require Equity Allocation of 75% and Debt Allocation of 25%. As you can see, strategy helps you take more risk when you are young and have many years to cover the risk, and it helps you to reduce risk as you approach near retirement age.

Now, let’s assume, market crashes and Amit sees his asset allocation changed to 65% Equity and 35% Debt, so he will be pushed for rebalancing. He will have to buy more Equity to regain balance. And in the case of market attains new highs his asset allocation might change to 85% Equity and 15% Debt, in such scenario Amit will have to sell Equity and buy Debt.

As you saw, Asset Allocation helps you take correct actions during market swings on either side. It is always advisable to rebalance once or twice a year instead of constantly rebalancing to avoid market volatility.

So, go ahead and define your own Asset Allocation strategy. You could have more aggressive or conservative strategy compare to one discussed here, but whatever you define try to stick with and enjoy benefits of Asset Allocation

Enjoy!


Also published on Medium.

 

Harsh