The goal of diversifying one’s investment portfolio is to reduce risk and enhance returns.
The goal of diversifying one’s investment portfolio is to reduce risk and enhance returns. Certain types of asset classes offer higher return potential but carry more risk. For example, equities are more volatile than fixed income securities, but historically have provided higher returns and capital appreciation. Fixed income or debt securities offer income and relative stability, but tend to have lower return potential. Benefits of different asset classes with low correlations can be combined in an asset allocation-based portfolio with a target level of risk that meets your investment goals and risk tolerance while avoiding the risks associated with putting all your eggs in one basket.
Your asset allocation strategy can be aggressive, conservative, or somewhere in between depending on individual investment goals, time horizon, and risk tolerance. Depending on your age, lifestyle, family commitments and liabilities, your financial goals will vary. You need to define your investment objectives such as buying a house, financing a wedding, paying for your children’s education or retirement before determining a relevant asset allocation.
As an example, a retired individual who no longer receives steady monthly paychecks, may resort to a conservative asset allocation with nearly 85% of the assets in low risk stable income generation products such as debt instruments and cash management products and a low allocation to higher risk asset classes such as equities. Conversely, an investor who does not need money for 25 years and is saving for retirement, seeking high capital appreciation, may have a more aggressive asset allocation with nearly 75% or higher allocation to equities and a relatively low allocation to debt instruments and cash.
Periodic reviews
While an asset allocation plan eliminates a lot of the day-to-day decisions involved in investing, it doesn’t mean you just set it and forget it. Reviewing your portfolio regularly with your financial advisor to monitor and rebalance asset allocation can help make sure you stay on track to meet investment goals.
No matter what allocation you select, it’s important to review your portfolio every 6-12 months to review your progress. But this process requires effort and discipline to track the periodic performance and review of asset classes and incorporate disciplined rebalancing. But given behavioral biases of humans and a lack of consistent investment discipline, asset allocation may drift away and pose adverse risks due to asset class concentration. Another common mistake on part of investors is to follow recent trends of the performance asset classes and succumb to herding while making investment decisions. Furthermore, disciplined rebalancing done periodically helps investors harvest a rebalancing premium and earn superior returns compared to investment portfolios that are not rebalanced periodically.
Asset allocation plan
Asset allocation, while relatively simple in theory, is difficult in practice. Allocation has to be reviewed every 6-12 months and periodically rebalanced. However, to mitigate the challenges such as a lack of investment discipline and the tendency of behavioral biases that may influence and introduce potential mistakes in asset allocation, investors may also consider asset allocation based fund-of-funds solutions that have in-built strategic and tactical allocations to different asset classes based on simple and well-defined rules.
Asset allocation is a potent solution for investors to build well diversified investment portfolios that aim to deliver superior risk adjusted returns that outpace inflation over the long haul. Embrace principles and discipline of sound asset allocation as you embark on the journey for long term wealth creation and wealth preservation. - Financial Express
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