As the market touches new heights every week, people are rushing to put their money into the equity market. However, as the legendary investor Warren Buffet says the most important rule in investing is preserving your capital, investors need to be cautious about their investment decision.
While it’s impossible to avoid risk entirely when investing in the markets, an investor can manage the overall risk by proper asset allocation.
Before understanding “Asset allocation,” one should know about the potential risk in financial markets.
What is Market risk?
Market risk is that the value of an investment will decrease due to changes in market factors. These factors will have an overall impact on the overall performance on the financial markets and can only be condensed by diversification into assets that are not correlated with the market — such as certain alternative asset classes. Market risk is sometimes called “systematic risk”.
In Investing, there are risks aplenty. The wide categories are: -
1) Business risk :-
A company has either raised capital by equity (by issuing stocks) or debt (by issuing bonds). The risk you take is the uncertainty (or) probability of how the company will perform and survive in the long-run.
2) Inflation risk :-
Inflation cuts the purchasing power of money, and each rupee can buy fewer goods and services. Which is the risk investors would be having on returns where the real rate of return will get impacted by rising inflation.
3) Volatility risk :-
A stock may experience unpredictability because of a change in the performance of products, management, dip in earnings, etc. It also experiences volatility due to market or political events. The volatile nature of stocks makes them risky in the short term, but in the long term, these variations tend to even out, in most scenarios.
4) Liquidity risk :-
A risk that you may not be able to discharge your investment when you need the money. One requirement is to have access to your money when you need it. Else, is it worth earning attractive unrealized gains when you cannot encash and realize it when needed?
What is the meaning of Asset Allocation?
Asset allocation is the process of deciding how much money to allocate across different asset categories such as equity, debt, gold, real estate, and cash.
The main motive is that the investor can lessen risk because each asset class has a different correlation to the others; when stocks rise, for example, bonds often fall. At a time when the stock market begins to fall, real estate may begin generating above-average returns.
An Ideal asset allocation suggests money should be divided among asset classes in such a way that the entire portfolio does not respond to the same market forces in the same way at the same time.
Example: Let us say, an investor, who has invested 100% in equities, without any diversification, where any correction leads to a huge fall in the portfolio. In that case, he won’t be willing to liquidate at a loss. Similarly, 100% for debt or any other asset class will affect the portfolio abruptly if not diversified. In recent times, bond issuances by corporates have become untrustworthy as a lot of companies (majorly NBFCs) are defaulting on issued bonds. So, one should have a healthy diversification in his/her portfolio to sustain in different market cycles.
Diversification in context to Asset Allocation :-
The concept of diversification is the process of investing in different types of funds or securities or asset classes to reduce risk, which is an important part of asset allocation. Diversification is also termed as a strategic partner for Asset Allocation, diversifying among different asset classes increases the chance that as one investment is falling in value, another may be rising.
A mix of assets may help position your portfolio to benefit during market upswings while suffering less during downturns. If you have sufficient capital, you can also diversify among investment styles to help address risk. For different market cycles, they prefer different asset allocation structures by diversifying towards different classes of assets.
Factors to be considered in determining Asset Allocation Strategy :-
Risk Tolerance :-
Risk tolerance depends on many factors such as age, income, willingness to stay (Time horizon), and liquidity needs. Above factors may differ from person to person from time to time and place to place.
Financial goals :-
Financial goals are targets, usually driven by specific future financial needs. Some financial goals you might set as an individual include children’s future planning, insurance planning, estate planning, investment planning, retirement planning, and tax planning.
Some benefits of proper Asset Allocation.
Optimal Return :-
Some investors are either too conservative or aggressive and invest accordingly, so they are unable to earn suitable returns on their investments. Proper asset allocation will help you to govern how much return you can expect on your investments based on investment risks you are taking.
Risk Minimization :-
Sometimes past experiences can misguide your investment decisions, though learning from past experiences is good; it is vital to follow an appropriate asset allocation meant for you to achieve your financial objectives. This will help you minimize risk on your investments and will also infuse more certainty on achieving your financial goals.
Helps investments to line up with time horizons :-
Along with the risk profile, your time horizon is also a key feature to decide the asset allocation, while you endeavor to achieve your financial objectives. Your time horizon will direct in which asset class you should invest an overriding portion of your investible surplus amount. Longer the time horizon of your financial objectives, the more you can incline your asset allocation towards equity and less towards debt.
Adequate Liquidity :-
Liquidity is also one of the vibrant aspects while making an investment decision as some investments have a lock-in period (closed time horizons) and can’t be redeemed within that period. Careful asset allocation will make sure that you have sufficient liquidity to pay for your financial objectives as and when required.